As a result of revelations relating to fund industry practices, people are watching investment companies closely. This heightened awareness presents a unique opportunity for our industry to come together to restore the trust of individual investors.
Funds have done a remarkable job of encouraging the public to build wealth. In the early 1970s, there were about 400 funds managing approximately $50 billion in assets. Today, the industry’s more than 8,100 funds manage $7.5 trillion in investments, including a substantial part of individual investors’ retirement holdings.
The trust that investors place in funds comes with great responsibility. The public expects funds to be managed in the interests of investors – who also are fund shareholders – and for investment companies to demonstrate that commitment in their governance practices, disclosure statements and fair treatment of all investors. While some companies have acted to strengthen particular practices, there are other steps to restore investor trust that all investment companies can consider taking.
As an institutional investor with more than $300 billion in assets under management, TIAA-CREF has long championed measures to assure that publicly- owned companies are governed effectively. We have taken the same approach to our own governance, periodically checking to see how we measure up to the standards we advocate for the companies in which we invest.
Early last year, TIAA-CREF undertook a comprehensive re-examination of its governance practices that led us to:
Even so, we know that we and other investment companies can do more. We see some steps the fund industry can take to demonstrate that funds operate for the benefit of shareholders, that their pricing and costs are open to scrutiny and that they treat all shareholders fairly regardless of account size.
A fund board should be comprised of directors with an undivided loyalty to the people who actually own the fund – the investors who hold fund shares. For more than 60 years, federal law has looked to each fund’s board of directors to oversee the fund’s investment adviser – the company that manages fund investment operations – and to manage conflicts of interest that the adviser has with the fund. But while the fund industry has grown dramatically in recent years, fund governance has not kept pace.
Certain governing structures can, at times, undermine a fund’s ability to operate for the benefit of shareholders. It may have been acceptable in the past for funds to simply have a majority of independent directors, but no more.
We support the Securities and Exchange Commission’s proposal that three-fourths of a fund’s directors, including the chairman, be independent of the fund’s investment management company. With independent directors already comprising a majority of directors at many funds, investment companies could phase in the three-fourths requirement at little added expense to shareholders. Boards should develop guidelines for determining whether their funds’ directors are independent and assess periodically whether directors meet those standards. In our view, an independent director should have no relationship of a professional, personal or financial nature that could undermine his or her ability to put shareholders’ interests first.
Over time, we hope that the fund industry will seriously consider the desirability of having boards of directors comprised entirely of independent directors. An independent board may be even more important to investment companies than their public company counterparts, which often have ownership factions of large institutional shareholders whose large-scale holdings enable them to act as effective advocates for the greater shareholder population. By contrast, funds tend to have diffuse ownership, with the result that there is rarely a large shareholder with effective power to monitor board performance. In light of this, shareholders of funds must rely even more on independent directors to protect their interests and to ask the tough questions of advisers.
There are other steps funds can take as well. We can remove many conflicts of interest by limiting membership on audit and nominating committees to independent directors, a practice consistent with exchange listing requirements for publicly traded companies. Fund directors can meet regularly and independently of the investment manager. Audit committees should each have at least one financial expert capable of leading the board’s oversight of the fund’s independent auditor. To ensure that directors are dedicating sufficient time and attention to their responsibilities, boards can develop guidelines governing the number of corporate board memberships their directors may have.
Shareholders should regularly have the opportunity to elect directors. There are varied ways to implement this, including a public company-style proxy process. We recognize that for smaller funds the cost of electing directors regularly may be prohibitive. For these firms, periodic elections may make more sense. However achieved, regular elections help to ensure board independence by making directors accountable to shareholders.
When it comes to improvements in governing structures, there is no single step that will transform a fund into one that is well governed. Lapses in oversight can and do occur. Ultimately, no governing structure, no matter how well conceived, can substitute for directors of high character, experience and competence. As the SEC has noted, the effectiveness of a fund board and the influence of its independent directors depend on both the quality of the directors and the governance practices they adopt.
If investors begin to doubt the integrity of the marketplace, their dollars will find another place to go.
The practice of “directed brokerage” for distribution can and often does involve a conflict of interest that undermines trust in the industry as a whole. In the practice’s problematic form, investment companies award trading business to a particular brokerage firm with the understanding that the firm will then favor that company’s shares.
This quid pro quo can make the broker more likely to recommend certain funds over others for reasons that may be unrelated to the customer’s needs, while enabling the investment adviser to use brokerage payments to finance marketing and distribution of fund shares without including such costs in its 12b-1 fees. Ultimately, it would be in the interest of both the fund industry and the investing public if such forms of directed brokerage were eliminated altogether. (Some forms of directed brokerage that result in brokers paying certain fund-level costs can benefit shareholders and should be preserved.)
In addition, we realize that in order to provide a high-quality product, funds incur expenses. Professional research is valuable and not free of charge. The quantity and quality of research – whether conducted in-house by the adviser or purchased from outside sources – affects the quality of investment advice and therefore bears directly on performance. The need for research is clear: the question is who pays for it.
At present, brokers include both execution of trades and brokerage research in their commission charges to fund managers. Most investment companies, including TIAA-CREF’s, pay for brokerage research through this so-called “soft dollar” arrangement. For purposes of comparing costs, it would be ideal if investment companies provided itemized disclosure of what is purchased with soft dollars. In addition to giving investors more information about the cost of their investments, this unbundling of research and trading expenses should lead to new efficiencies, as advisers will then purchase the research they find most valuable at the lowest negotiated rates.
To that end, we call upon the brokerage industry to separate trading costs from research costs so that investment advisers can disclose them to investors. Ultimately, advisers should be paying for research in hard dollars from their own profits, thereby ending soft dollar arrangements. In the interim, the fund industry would do well to closely examine proposals to improve soft dollar disclosure, paying particular attention to the preservation of high quality research and the achievement of true transparency. With the right focus, over time one can expect a more efficient market to evolve, leading to an optimal amount of research and an equitable way of paying for it.
Fund shares are sold to investors in a variety of ways. Some companies market chiefly to institutional investors or short-term investors. Others appeal to people saving for the long term. Fund fees and discounts can vary among groups of investors within a fund depending on whether the fund is sold directly or through a broker, or the quantity of shares purchased. While these distinctions may be appropriate (and should be fully disclosed in fund prospectuses), no shareholder should get preferential treatment other than as disclosed.
We should pledge – industry to customers – a fair deal. For example, funds should not share confidential information relating to holdings or trading strategies with certain shareholders who can then profit from that information at the expense of others. Funds should also develop policies and procedures to address abusive short-term trading and market timing and should apply these policies consistently.
Given their importance to America’s financial future, the success of funds is in everyone’s interest.
In our ongoing pursuit of that successful future, TIAA-CREF has developed principles for the governance of funds that our investment companies aspire to meet. We will apply these principles both to our own funds and to funds from other companies that we offer our customers. To make suggestions as to how we might improve them, e-mail us at principles@tiaa-cref.org.
We have a continuing opportunity to strengthen the public’s trust while helping to prevent the recurrence of damaging scandals. Committing to an open and honest discussion of how best to serve the public’s interest can only improve the fund industry’s long-term prospects.
June 2, 2004
© 2008 and prior years, Teachers Insurance and Annuity Association - College Retirement Equities Fund (TIAA-CREF), New York, NY 10017
