Memorandum on the Issues, Opportunities, and Challenges Facing Portfolio Managers in the Coming Decade

By: Khaled Sultan
Date: April 28, 2006

Introduction

Today’s investment environment is a challenging one for all of its participants. Things have come a long way since the turn of the past century, and a deeper analysis of the investment industry is required to understand how it will change in the future. The following memorandum aims to discuss the various issues, opportunities and challenges facing portfolio managers of large balanced mutual funds over the next decade. We will begin with a brief description of portfolio management and some historical background on the industry. We will then continue the discussion around the underlying issues. Some of the issues we will put forward are arguably as old as the profession itself, including the fiduciary duty a manager has to her clients. Other issues, on the other hand are expected to gain some light in the upcoming decade, especially issues such as ethical and environmentally friendly investing. We will also address some of the upcoming challenges in this business including the various management and research fees charged to clients by their fund managers, and the degree of transparency of those fees, or lack thereof. Our discourse will also highlight the future investment environment which is expected to continue to be constrained by growing regulation, and compliance burdens. The memorandum will aim to be comprehensive, however much of the discourse will be focused on the major issues expected to gain prominence over the upcoming years.

Portfolio Management

Portfolio management deals with the construction and maintenance of a collection of investments. Portfolio managers are the professionals who are entrusted with the responsibility of creating the best possible collection of investments for each customer’s needs and circumstances. Guided by a statement of investment policy, which outlines the return requirements, the investors’ risk tolerance, and the constraints under which the portfolio must operate, the portfolio manager aims to maxims her customers’ expected return while taking on the least amount of risk.

The funds management business began in 1924 when three Boston security executives pooled their money ($50,000) together to create the first official mutual fund in the United States, the Massachusetts Investors Trust. Today, mutual fund companies have evolved into becoming financial intermediaries that invest the money received from unit holders in accordance with a specific mandate known to all investors before they subscribe. Since the early 1920s, the funds management industry has changed quite a bit. As of last year there were more than 1,800 mutual funds in Canada representing over 50 million unit holder accounts and assets under administration worth $608.6 billion (US$16.06 trillion globally). Despite the evolution of the industry, many of the issues that the early managers had to deal with are still applicable today, and will likely continue to persist in future years to come. New issues, opportunities, and challenges have also come about making this industry as exciting as ever.

Fiduciary Duties and Responsibilities

Fiduciary duties and responsibilities have been, and continue to be one of the main issues that concern investment and fund managers both in Canada as well as around the world. Fiduciary duties are in fact at the center of all the other issues, challenges, and opportunities that we will outline below, including the recent industry scandals and their regulatory repercussions, management fees, and environmentally friendly investments.

A fiduciary is a person or an institution that manages money and/or business affairs for another person or institution. Fiduciary duties are those that common law jurisdictions impose upon a person who undertakes to exercise discretionary powers in the interests of another person in circumstances that give rise to a relationship of trust and confidence. This underscores the fact that all fund managers carry fiduciary duties that they must adhere to. The prudent man (investor) rule is at the heart of modern fiduciary standards, and centers around fiduciaries’ responsibility to use good judgment and make long-term decisions for the benefit of their clients in a manner consistent with how reasonable people manage their own money. Fund managers are responsible for taking decisions that are free from conflict of interest issues, and are intended on maximizing the client’s value, and not that of the manager herself.

Fund managers must be aware of the trust relationship between them and their clients (whether implicit or explicit), and must never be complacent about holding their customers’ interest in high regard. Disregarding such a duty can have severe consequences and result in severe financial repercussions, as we will highlight below. This will continue to be an issue that fund managers must be aware of, and have to adhere to in many years to come.

Mutual Fund Scandals

Unfortunately, the fund management business is as susceptible to scandals as any other business. Scandals arise when the fund manager disregards her fiduciary duties outlined above and neglects to act in the best interest of the fund unit holders. The most recent example of this is the case of the late trading and market timing transactions that took place at Bank of America. Bank of America permitted the Canary fund to engage in market timing transactions in its Nations Funds, allowing it to buy and sell fund shares after the market closed while still getting that day’s price. It, in affect, allowed the fund to profit from late news that was expected to move the price on the following trading day. In this example, the management company allowed the exploitation of stale securities prices at the expense of the fund’s other investors.

A 1999 study by Roger M. Edelen, former finance professor at Wharton, concluded that traders could make sizable profits by exploiting stale prices. Eric Zitzewitz, professor of strategic management at Stanford Graduate School of Business, concludes in a recent study that late trading is widespread, occurring in one out of six fund families and costing investors $400 million a year since 2001. He concluded that market timing costs investors about $4 billion a year. While the actual dollar figure associated with costs to investors is up for debate, the fact that mutual fund scandals are taking place, and hurt investors, is not.

In January of last year, another lawsuit was brought against over 40 mutual fund managers by shareholders in the U.S. due to another investment scandal. The lawsuit cited the managers’ failure to collect more than US$2 billion in settlement pay-outs to which the funds’ shareholders would have been entitled. The lawsuit alleged that the failure to claim this money during the three-year class period dating back to January 2002 was a breach of the fund managers’ fiduciary duty.

Such scandals tarnish the reputation of the mutual funds industry, along with its professionals and managers. The challenge to fund managers is to always focus on the interests of the individual unit holders no matter how much pressure she is under not to do so. Once again, strict adherence to fiduciary responsibilities is essential for managers in the upcoming decade.

Regulatory Burden

The recent scandals above have shaken the confidence in the governance of mutual funds, and resulted in increased scrutiny by the U.S. regulators. Prior to September 2003, the Securities and Exchange Commission (SEC) did not examine mutual fund companies for trading abuses such as market timing violations. This was because the agency viewed other activities as representing higher risks and believed that companies had financial incentives to establish effective controls. This has since changed. New regulations recently introduced require that the Chairman of a fund be independent of the fund manager and that 75 percent of its board of directors must be independent of the company’s investment adviser. The SEC also adopted rules that require mutual fund companies and investment advisers to appoint chief compliance officers (CCO) who are responsible for monitoring compliance with laws and regulations. The SEC also requires mutual fund company CCOs to prepare annual reports on company policies and violations.

Fund managers are likely to experience a lot more regulatory changes in the coming decade, as governance standards are raised as a response to some of the large corporate scandals that have recently occurred. These changes are the regulator’s attempts to protect investors and ensure that their interests are paramount in the eyes of their fund managers. Regulation will further push mangers towards more transparency and to establish stronger elements of independence. These changes should not be taken lightly as they will invariably introduce additional compliance costs and add to the already growing regulatory burden placed on fund managers (and others in the business). This will constitute added challenges to the fund manager, but are imperative to restore investor confidence in the fund management business.

Management Fees

This is one of the most important issues that fund managers must be cognisant of and will have to contend with in the coming years. Managers have to deal with conflicting pressures, trying to properly serve fund investors meanwhile having to also serve their management companies. There is an obvious and direct relationship between the management companies’ profits, and the amount of fees they are able to pass through to the fund holders. The investors on the other hand realize higher returns when fees are kept to a minimum. Therein lays the problem.

One could argue that management companies do best when their funds attract as many investors as possible and hence such competitive pressures limit their urge to maximize fees as much as possible. Recent research however contends this, and suggests that managers do exploit opportunities to maximize fees, often using techniques that make fees virtually invisible to investor, and therefore clearly violate their fiduciary responsibilities to their clients.

Prior to 1980, fund companies were required to absorb costs associated with the funds’ marketing and distribution, typically expensing them out of their own revenue, the management expense ratio (MER). The SEC later adopted Rule 12b-1, allowing for such fees to be passed on to investors. The rational for such a rule was that it actually helps investors since it would lead to a reduction in other expenses due to economies of scale, since marketing would draw more investors to the funds. What ended up happening however was that funds that passed through the marketing and distribution costs did not compensate by lowering the other expenses, irrespective of how many new investors were drawn to the fund. By 1983, about 24% of funds charged 12b-1 fees, and the figure climbed to 61% by the end of 2002 however no compensating lowering of the other expenses took place. One must note those retail investors are the ones most susceptible to this, since institutional investors are better informed, carry more clout, and are able to better protect themselves. Institutional investors typically are better able to resist such pass through fees.

Research costs have also been slowly and discretely passed on to investors. The same research suggests that fund companies pay for such research through “soft dollars”, where brokerage companies (those supplying the research) execute trades for fund managers in exchange for higher commissions. Since those commissions are paid from fund assets and not from the manager’s MER, the research costs are in all intents and purposes being paid for by the investors. Most retail investors are probably unaware of such added costs that in affect lower their overall returns.

Managers are tempted to maximize their short-term profits by shifting expenses to investors, but this practise may not be profit maximizing in the long-run. Given the current increased sensitivity of investors with respect to governance, accountability and disclosure, the practice of shifting expenses, either via soft dollars or 12b-1 fees, especially if it raises expenses to investors without their knowledge, could develop into a serious problem for mutual fund providers. The voice of criticism against management fees has been getting louder, especially when such opinions are held by the most prominent in the investment industry. Fund mangers must pay close attention to their fee structures, and not forget that their fiduciary duty requires them to maximize their clients’ returns, and not their own.

Performance Measurement

Fund performance is, and will continue to be one of the challenges that fund managers have to address. The issue lays in the fact that the typical horizon of a fund manager is longer term, which is usually based on the investors’ time horizon. Fund managers however are assessed on a more frequent basis, that being quarterly or semi-annually. The problem with this is that this indirectly impacts the fund managers’ behaviour, making them focus more on short term results, at the expense of the long term performance. The problem becomes even bigger when the investors themselves are looking for longer term portfolios, yet insist on closer scrutiny and more frequent assessments of their managers. Long term portfolios should ignore short term price fluctuations, and hence allow managers more breathing space.

Fund managers should tackle the issue of performance measurement directly, and turn it into an opportunity. They should do their utmost to persuade their clients to asses them over a longer period (e.g. 1 to 2 years) instead of the current assessment frequency. Doing so would go a long way in smoothing out the inevitable short term price movements and fluctuations in performance.

Investments and the Environment

It is not quite surprising that environmental issues did not play a major role in guiding fund managers’ investment decisions in the past. This perhaps stems from fund managers’ belief that environmental concerns are not yet material to stock valuations, or that their fiduciary responsibility require them to solely pursue profit maximizing decisions while disregarding other “softer” objectives (which may in affect be harmful to investment returns). Perhaps the most important reason is the tendency of fund managers to ignore issues which inherently are of a longer-term importance (e.g. environmental issues), because they are less relevant to their performance. One must keep in mind that fund managers are almost always evaluated based on short-term/quarterly returns, regardless of what their investment horizons are.

There is some evidence to suggest that this has been changing and that the managers’ awareness of environmental issues is increasing. A 2005 survey of 195 fund managers from around the world by Mercer Investment Consulting revealed that the use of positive screening for environmental, social and ethical factors is entering mainstream investment analysis particularly where such screening may potentially yield superior financial performance by targeting companies that adopt socially responsible practices and thereby avoid future liabilities and losses. The study revealed that 70 per cent of fund managers believe the integration of environmental, social and ethical factors into investment analysis will become a mainstream part of investment management within three to 10 years.

Despite this level of awareness however, a concrete connection between awareness and investment decisions and strategies is still absent. Most portfolio managers in North America do not distinguish between addressing environmental risks/opportunities on the one hand and socially responsible investing on the other, placing the North American investment community behind investors elsewhere in the world, who are more open to including environmental information that is financially relevant. The situation is especially worse in Canada, which lags behind the United States with respect to the integration of environmental issues into stock valuations.

Fund managers must recognize that government pressures will likely push them to recognize the inherent long-term environmental risks and opportunities in their investment practices. Fund managers should not wait until their asset-owners push for change on this front, since the responsibility for deciding where the majority of such assets are invested lay with the fund managers themselves, and not the owners.

Qualitative factors such as management quality, corporate governance, market conditions for new products or services, and employee relations are currently being incorporated in investment valuation. Valuation tools therefore do exist to integrate the more qualitative factors and should be used to include environment factors as well. Fund managers cannot be complaisant with regard to environment sustainability, as this will have more of an impact on their industry in the future, and may be another metric by which their performance is measured.

Conclusion

The majority of the issues, opportunities and challenges facing portfolio and fund managers in the coming decade revolve around their fiduciary duties towards their clients. This duty requires managers to ensure that the clients’ interests come before their own. This duty is as old as the portfolio management profession, and will likely remain to be the number one issue that managers must be aware of for years to come. The recent scandals that affected the fund industry have been quite unfortunate, but should not have been unexpected. The newly introduced regulatory changes will help in restoring some of lost confidence in the profession, but managers must be proactive, and transparent in the way in which they conduct their business to ensure that investors’ confidence is restored sooner. Fund managers must be careful in how they structure their fees, and must not solely focus on short term gains to the determent of their longer term investment objectives. The fund managers’ fiduciary duties also require them to maintain a high level of ethical conduct. Such ethical conduct should not be though of only in terms of not breaking the law, but rather needs to be viewed from the perspective of doing what is good. Environmental investing issues are also likely to occupy more of managers time in the future, and fund managers should take this as a challenge to continue to deliver great results, yet with sustainability in mind.

Copyright ©, 2007 Khaled Sultan. All Rights Reserved.

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