Issues on the Boardroom Table

Issues on the Boardroom Table

Perspectives and commentary on current issues of Board and adviser interest.

Artificial Intelligence – Considerations, Probing Advisor Use of AI
(January 2024)

The use of artificial intelligence (AI) tools in the financial services industry has generated much discussion, criticism, and concern over the last several years. Use of AI in all aspects of business has spread faster than anyone could have imagined. Perhaps most concerning, some of the applications are being developed, embraced quickly and arguably with limited validation. While some output from AI tools has been invaluable and saved valuable human resources, some AI-generated results have been clearly ‘fake’ and wildly unpredictable. Most detractors cite data source validation and human intervention for logic and accuracy checks as vital (and not always utilized). Most observers claim that AI can abbreviate or speed some processes, but cannot reasonably and fully replace human research and critical review. AI use in many aspects of fund management and some level of SEC oversight appear inevitable.

Undoubtedly, many – if not all – fund advisors have explored what AI may do to support their businesses, back-test investment theories, expand productivity, widen security research, and elevate client satisfaction, amongst other applications. From my vantage point, the uses can have almost limitless advantages if used prudently, with reasonable skepticism, and with extensive human intervention. Data sources are not always valid and dependable. Contradictions abound. Output can be non-sensical when scans and logic checks are performed. Extensive testing, source validation, text/data source research, and data ‘scrubbing’ is advised.

Trustees should undoubtedly be aware of, and to what extent, AI is being used by their fund company to support any and all functions. A few questions that may be posed by Boards when probing into AI use to presumably enhance fund management and operations. First, is your funds’ advisory firm using AI and why did it decide to do so? Second, how does your AI software operate and generally perform search functions and put forth any conclusions or recommendations? Put another way, would your Board be comfortable not knowing some details of your advisor’s AI functionality? Third, has the Board considered whether a fund or its advisor should bear the cost of any AI licensing? Has counsel been involved? Fourth, is your Board aware of the details of (presumably rigorous) human oversight and ‘filtering’ of AI results prior to application of AI recommendations? Fifth, has your Board considered how the use of AI may, or should, impact the level of a “reasonable” management fee? Lastly, how should performance results of an ‘AI-dependent’ fund be judged in relation to non-AI peers? Is expecting an AI “learning period” and likely selection misfires acceptable? What about prior back-testing?

Lots of open questions. A world with embedded AI has clearly just started to form – some advisors will ‘tip toe’ and others will dive in. Trustees should make diligent, best-faith efforts to grasp the potential and long-term impacts of AI on fund management, as applicable. As expected, Trustees need to be informed to the extent that appropriate, probing questions may be posed to gain comfort with any AI use. AI’s probable wide-spread use in the industry may not be that far away.

Is your Board comfortable with the ‘AI-supported’ operations your advisor is embracing?

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Documenting 15c Processes – Thoughts, Considerations, Pitfalls
(March 2023)

To minimize SEC concerns over inadequate 15(c) processes, some Boards have begun considering whether to document their procedures and/or policies related to advisory contract renewal. I doubt the business is clear what proportion of Trustees currently support this notion (or already have documentation in place). And, the jury is still out on counsel’s reaction to this clearly defensive, front-running maneuver. While creating some sort of framework, guidelines, roadmap, or even checklist will help guide Boards through the twists and turns of the contract renewal process, surely this exercise can also be fraught with peril, similar to having a shoddy or incomplete process.

Allow me to put forth a few matters that should likely be pondered prior to a discussion of 15(c) process documentation. First, what risks does outside counsel feel are present when writing down procedures and/or policies? Second, what processes would Trustees utilize to reach full consensus on what subjects and/or details some type of roadmap may contain? Third, how can the language be crafted such that it remains applicable over many ‘15(c) cycles’, does not require a re-write as the business arguably evolves, and sidestep potential human errors each time edits are undertaken? Fourth, what underlying principles might be appropriate – and clearly cited – to guide the authoring of such a document? Fifth, how much detail should any document contain or should it be void of any details? Would detail-starved language be sufficient to satisfy SEC examiners? Sixth, would comprehensive documentation serve to reduce Trustee flexibility, stifle judgment, and effectively pigeon-hole oversight or decision-making? Lastly, might an unwritten, merely oral agreement amongst Trustees be sufficient to point Boards in the right direction as opposed to a rigid checklist of desired topics or action items?

In the event Trustees decide that a “principles-based guiding document” would be useful to satiate the SEC, ensure all pertinent topics are on the advisory contract renewal docket, offer some solace that processes and policies are consistent year-over-year, and provide a clear understanding of the 15(c) goals across all Trustees, here are some considerations that may be useful:

Do the covered 15(c) topics match what counsel believes the content for which the SEC is truly searching?
Might process simplification potentially result in the lack of unique, yearly factor oversight by the Trustees each year?
Might the document become a ‘crutch’ and facilitate identical approaches to 15(c) each year (which likely is not defensible, appropriate)?
How might any documentation be used by litigators in 36(b) lawsuits?
Are all Trustees comfortable with the document’s possible inescapable nature of shackling Trustees into a ‘renewal model’ and reducing inherent flexibility and on-the-fly judgement?
Are the outlined goals still applicable for this year’s cycle?
Who is tasked with reviewing the documentation each yearly cycle to ensure that business changes and continued evolution has been accounted for?
Has the Board followed, to the letter, every policy and procedure outlined in the guiding document (to the extent detailed)?
How do the lessons taken away from 36(b) litigation match up with the roadmap outlined in any 15(c) documentation?

This list of considerations is clearly not comprehensive, yet offers some thoughts that arguably should enter any Board discussions regarding 15(c) process documentation. And, as always, outside counsel should be consulted when making policy decisions put down in writing with possible dire consequences lurking in the background (like many Board actions!).

All in all, I will guess that Trustees will approach this topic with much ambivalence. There are pluses and minuses on both sides of the “put it in writing” concept. Consistent guidance and approaches to many Board issues are positive, yet less Trustee flexibility is hardly useful. Documentation can promote myopic behaviors and stifle alternative view and strategies. Yet, a roadmap is helpful to keep Trustees focused on relevant, perhaps shifting information and core decisions. Many Trustees may reach the conclusion that a topic- or principles-based approach to documentation may achieve consistency, while shunning material details that discourage very appropriate, unique discussions each year. However, with many Board decisions, the optimal path may be very complex-specific.

A very rigorous Board pondering of 15(c) documentation (or not) – with outside counsel – is clearly warranted and should be approached with a macro view and caution. Care, diligence, and attention to detail is always the hallmark of successful Boards – an attribute that will be on display during such a roundtable discussion.

Do tread lightly.

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SEC Sweeps Fund Fees, Board Approval – Does your Process Stack Up?
(September 2022)

Recently reported in BoardIQ, the SEC is currently conducting sweeps of supposedly targeted fund groups analyzing their advisory contract renewal processes, the exams coined “36(b) sweeps” (after a Section of the Investment Company Act of 1940 which gives shareholders the right to sue a fund advisor for charging allegedly “excessive fees”). The purpose of the sweeps is to examine processes and procedures used by advisors and Trustees to approve fund management fee contracts. Observers have postulated that the SEC may also invoke their right to sue certain advisors alleging they have levied excessive fees.

Based on a review of prior 36(b) case summaries – and my prior experience in excessive fee litigation – a solid 15(c) process is arguably vital to a solid defense during such exams or filed lawsuits. If Boards expect, help craft, and are actively involved in a carefully engineered advisory contract renewal process, there is a high likelihood that a Judge in a bench trial (or jury in some cases) will defer to Trustees’ business judgement and rule in favor of the defense providing the processes employed by a Board are comprehensive, follow the basic principles laid out in Gartenberg (1982), the Trustees demonstrate care and diligence, and the thoroughness of data and information afforded the Board are adequate, amongst other factors.

The core process attributes an SEC examination may seek to review – in an effort to uncover deficiencies – are numerous. First, the basic business background and professional qualifications of the Trustees. Second, the scope of information on which the Board relies to renew the advisory contracts to validate that it encompasses all relevant operational factors of fund management (internal or outsourced). Third, the precise steps shown in the formal record as to how the advisory contracts were renewed (accompanied by supporting paperwork). Fourth, the reliability, accuracy, and applicability of the benchmarking materials provided to the Trustees for their assessment of relative fee levels and investment performance rankings. Fifth, the Trustees must have not only reviewed all materials provided in detail but have also asked follow-up questions and probed where more color and background aids the application of their business judgement. Sixth, consideration by the Trustees of factors such as economies-of-scale, “fall-out benefits,” profits realized by an advisor, fees of other managed accounts, and any other relevant factors must have been undertaken. Seventh, the quality of services provided by an advisor should have been demonstrated by the advisor and considered by the Trustees. Lastly, the care and diligence employed by Trustees in considering funds’ advisory contract renewals should be evident from the documentation. I would argue this is not necessarily a comprehensive list.

In addition, KFS understands that, as part of their sweep, the SEC is carving out and paying special attention to fund complexes with funds ranking in the lowest quartile for long-term performance and highest quartile for current expense levels. While this statistical approach can highlight several issues with the process used by, and judgement of, the Trustees it also should surface topics such as fund categorizations by an independent rating agency, changes in strategy, specific focus on volatility which intentionally buffers upside returns, the “end-point dependency” of the returns examined, use of a sub-advisor, the homogeneity of the strategies utilized in a category, fund mergers, and the like.

A few example issues that Trustees could be surfacing amongst themselves prior to being placed in the crosshairs by the SEC (or their arrival at the front door!), may include:

Were the appropriate advisory personnel involved in the 15(c) process?
Did the advisor address the Board’s data and information requests in a timely fashion and with great care?
Was an adequate amount of time dedicated to discussion by the Board of the advisor’s responses to documented questions or in-person discussions regarding vital issues?
Were all Trustees fully prepared to discuss the materials provided?
Do some bottom quartile return/bottom quartile expenses exist? If so, what actions have been taken to rectify the perpetual bottom dwellers?
Does the formal record accurately depict the ways in which the 15c process unfolded?
Subsequent to the 15c questionnaire and in-person Board meetings, do the Trustees feel “well-informed?”
Have all Board and counsel questions been addressed by the advisor to the Board’s satisfaction? Is there a follow-up plan for issues that may linger beyond the funds’ renewals?
Are the Trustees comfortable that the data provided by the advisor is comprehensive, applicable, accurate, logical, and in line with prior data?
Does the process allow the Trustees to fully achieve sufficient background, information, and details to skillfully and adequately apply their business judgement?

The litigation record of the funds business has proven that one of the most important ways a Board can insulate itself from exposure in 36(b) suits is a bullet-proof advisory contract renewal process. While the above noted core areas should be considered and built into iron-clad procedures, there are surely many, many details that require a Board’s attention. In this space, asking questions, being diligent, plugging procedural holes and masking process exposures is all about the what-seem-to-be-small details. Finally, do not hesitate to engage counsel heavily.

Ensuring your process “stacks up” is an endeavor worth the effort, aligns with case lessons, and will likely thwart 36(b) litigators hungry to get that first win against the funds business. Industry experts are not sure what tactics will be employed by new excessive fee litigators, but a strong 15(c) process is a foundation on which fund complexes and Boards can build a solid defense.

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Allianz Investor Fraud Plea Agreement – Board impact?
(May 2022)

According to filings with the Securities and Exchange Commission (SEC) and recent reporting in the Wall Street Journal (WSJ), Allianz Global Investors US (a division of Allianz SE or simply “Allianz”) has pleaded guilty to securities fraud and will pay substantial restitution, financial penalties. In addition, KFS understands that, per Section 9(a)(1) of the Investment Company Act of 1940 and due to plea agreements with the US Attorney’s Office and civil fraud claims brought by the SEC, Allianz may no longer act as investment advisor for any RICs – most prominently as part of the Allianz fund complex – for a period of 10 years in addition to some pension plans. Therefore, new advisors and sub-advisors must be selected for the funds for which Allianz served as advisor or sub-advisor, respectively. This advisor-less fund scenario is not dissimilar to when a Board decides to not renew fund advisory contracts and must search for a new investment advisor – this has only happened in a few cases in the last several decades. Allianz has a surprisingly short period of time to transfer their RIC units to a new investment advisor.

The fraud charges originated from SEC discoveries that personnel at Allianz in their private-investment funds division neither had adequate internal controls in place nor practiced proper execution of the investment objective, and oversight of the division with regard to risk mitigation or data reporting was insufficient. Fraudulent actions included not purchasing sufficient options to counteract market movements, mischaracterizing the success of risk mitigation techniques, funds’ likely performance during times of market turmoil, and mis-stating recent investment performance, amongst other misleading disclosures.

The WSJ reported that Allianz would transfer all of their RIC assets (open-end, closed-end, underlying variable annuity) to Voya Investment Management for an equity stake in the pooled fund complex/money manager. The details of how this decision was reached are not clear to KFS at this stage of the ‘deconsolidation’, why Voya was selected, if the current Allianz fund Trustees were involved, what stipulations were made by the SEC regarding the manager transition away from Allianz (if any), and if the very aggressive timeline proposed by the SEC for the asset transfer can be achieved. Suffice to say that, given the proposed time period, the new Voya fund unit will not be fully ‘absorbed’ by the acquirer, but rather ‘glued on’ … at least for now. Fund mergers, name changes, personnel changes, and service provider changes are likely forthcoming.

From my standpoint, the core fiduciary question that arises from this event is: were there subtle signs that Allianz’s policies and procedures for addressing risk, monitoring personnel, reporting accurate data, characterizing investments’ likely returns (and similar issues) were insufficient? Thus, what disclosures to the Board were insufficient or misleading, if any? Were the Trustees simply uninformed or misinformed, policy disclosures appeared plausible, and fraudulent actions behind the scenes were masterfully cloaked? Were the fraudulent behaviors confined to the private investment fund unit and did not ‘bleed’ into or impact the more retail side of the business? Or, were the risk oversight and disclosure review efforts of the advisor for all RICs systemically anemic? How did the three Allianz employees who were charged and relieved of their portfolio management duties sidestep the alleged checks and balances? Did they act alone? Lots of unsettling question emerge from this unprecedented and SEC-mandated advisory contracts’ removal from the incumbent investment advisor.

One would have to guess that – after news of this event reaches other Boards and fully plays out – Trustees of other complexes will be deeply troubled by the breach of trust by the advisor’s investment management personnel and are vindicated in their belief that “trust but verify” is a valid approach to fiduciary oversight. Yet, a robust and perhaps elevated amount of skepticism may occur across the business. While the funds business will arguably survive and continue to thrive, fraudulent events like these can be a source of pain for Boards and managers alike and, in some cases, should precipitate a bit of digging to uncover less-than-ironclad processes. This is not to say that advisors should not – without definitive cause – be trusted and efforts to meet compliance requirements are inadequate. In KFS’s experience and within understandable operational constraints, fund advisors generally make “best efforts.”

Yet, what should some Trustees take away from this event? Allow me to propose a few questions, things to ponder, and practical considerations placed ‘on the Boardroom table.’

Does your Board regularly practice the maxim “Trust but Verify?” If not, should you?
Are you comfortable with the amount of detail and evidence provided to the Board by your funds’ advisor with regard to certain processes that ensure compliance?
Do your Trustees conduct regular ‘logic checks’ on data provided the Board, i.e., do regularly provided numbers make sense quarter-to-quarter based on disclosures and market conditions? Would historical context assist this process?
When data occasionally appear perplexing or non-sensical, are advisor personnel brought in to offer answers and/or are written explanations required?
Do some Trustees embrace the notion that consistently stellar returns are unlikely and thus, the Board should ask more questions about investment process and strategies? If not, should you?
Have the mathematics and assumptions behind projected investment returns been clearly documented and/or explained to the Trustees?
What compliance or third-party oversight exists to validate any performance data provide to the Board? Can this validation step be side-stepped in any way?
Is there full alignment between shareholder disclosures and investment techniques and returns that are actually practiced, realized, respectively?
Are the investment techniques employed by your funds understood (in general terms) by every Trustee such that each person could give a layperson’s explanation?

[This is clearly not a comprehensive list, but nonetheless surfaces some valid topics for consideration.]

As the sports metaphor goes (and considering the current NHL play-offs), the puck is in Trustees’ end of the ice. What will your zone breakout and offensive efforts look like? How might the unfortunate event cited above alter the way Trustees approach their job, if at all? If the aforementioned scenario makes some Boardmembers nervous, what added information or due diligence would calm those fears? Is the trust you have placed in your advisor fully warranted? Precisely what information, data, and empirical evidence is that potentially implicit trust based on?

I will go out on a limb and guess that the Allianz charges will spur many more Board inquiries, probing, and general due diligence at some fund complexes. And, that’s not a bad outcome for the health and image of the business-at-large.

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Board Issues, Challenges in 2022 – A ‘New’ Year?
(January 2022)

The year 2022 is upon us. The frustrations, restrictions and challenges of 2020 and 2021 are behind us. It’s a fresh new year, or is it? COVID-19’s omicron variant continues to spread aggressively, our country is arguably still very polarized, civil unrest is not abating, the mid-term election battles are brewing, climate change perspectives are divergent, ESG funds remain less-than-homogenous in their approaches, supply chains are clogged, inflation is on the rise, progress on the legislative front has frequently been stymied, and very controversial SCOTUS decisions are on the horizon. 2022 seems like a possible 2021 redux.

It is easy to argue that most, if not all, of these events or predicaments will help to drive economic growth, security markets, and prices of most tangible assets around the world. Portfolio managers responsible for $Bil of shareholder assets will frantically be attempting to determine the winners and losers impacted by these factors, a chore which is not suited for anyone without immense resources, expert-level insights, and vast knowledge. Trustees should fully comprehend – through a variety of outreach and communication means – managers’ investment management strategies to navigate these uncertain waters, the adequacy of available analytical resources, support systems, and fact-based projections for market impact. This is not to say that Trustees should be providing definitive guidance or strategies to the portfolio managers, only understanding the dedicated personnel, systems, and logic behind investment decisions.

COVID-19
The coronavirus has continue to put a significant crimp in economic growth around the world, an unavoidable phenomenon whose end is not yet in sight. What sectors will be the big winners when the virus has seen its last unprecedented spike? When might that be?! When will the dearth of employable, willing workers start to subside? Will immigration policy play a role? What big names in pharma will benefit the most from various, likely new, COVID treatments? What roles will the Biden administration assume in the continued fight against COVID? It seems there are more perplexing questions than answers.

ESG Fund Names
The business of operating and managing environmentally-, socially-, and governance-focused funds should continue to evolve over many more years as definitions and standards placed on the use of related monikers develop. There are many ways to benchmark “green-ness” and measure success in the space currently. In the meantime, advisors appear to be capitalizing on elevate demand for products leveraging certain naming conventions. Use by funds of terms such as “green”, “sustainable”, “climate-conscious” and the like do not translate into identical security screens for purposes of portfolio management. Every “green” fund is not like every other supposed green fund. Boards should understand the level to which a fund adheres to each of the many potential ESG factors and the validity of potentially bogus comparisons to other ESG products. Is a fund’s approach, and application of, ESG factors an evolving strategy? How equitable are comparisons amongst other funds billed as ‘peers’ when exact approaches to ESG screens could be opaque? When naming and definitional standards are solidified, will a fund be forced to alter their security selection techniques, disclose modifications to shareholders, and ‘back off’ of previously embraced performance comparisons? How does a Board audit or validate that ESG-focus claims are indeed being embraced and have been fully implemented?

Climate Change
Perhaps surprisingly, general views on climate change are hardly aligned. Even the most prominent climate scientists in the world do not agree on the extent to which climate change will alter the weather patterns, atmosphere, and the livability of our planet. Yet, most agree that climate is dramatically shifting to the detriment of our quality of living. The progression of disturbing trends in extreme weather events, rising temperatures, a deteriorating ozone, fire danger, and elevated sea levels will present many challenges for all who inhabit the Earth! However, these challenges will provide enormous financial opportunities for those who understand precisely where the climate research is headed and which products or inventions will lead the way towards intervention or avoidance. In my view, this topic is too gargantuan – financially or otherwise – for any money manager to ignore. Boards should actively probe and monitor to what extent and how (not if) fund portfolio managers are enthusiastically researching and participating in this space. I am confident deniers will not be treated kindly in the performance ratings.

Mid-term elections
One can easily argue that highly partisan viewpoints have moved to more inflexible stances over the last 4+ years. The gap between blue and red is not shrinking and the margins in both houses of Congress will be hotly contested come later this year. Thus, given the likelihood of continued partisanship, successes by either party in the mid-term elections will very likely determine policy and – in political vernacular – dramatically heading left or right. As with climate change, control of one or both houses by one party may determine the fate of many segments of the American economy. Portfolio managers who ignore the election outcomes do so at their own peril. Trustees should ask for economic and market projections from their investment managers regarding post-election impact given political scenarios that are likely to play out.

Inflation, Interest Rates
What was supposed to be a transitory period of rising prices turned into a much stickier period of inflation, still persisting to this day. Productive capacity is down due to COVID and the inability to hire workers which has spurred rising prices. Some economic pundits predict that rising prices may be a persistent phenomenon for several years – the monetary, demand, and spending paradigms seems to have shifted … and perhaps permanently. “Stagflation” and “secular stagnation” are distinct possibilities and measures to tame ‘prices gone wild’ which have worked before may not meet with success. Boards should be up to speed on what investment staff believe are the current drivers of interest rates, growth, and inflation and the likelihood of numerous factors crimping economic growth (and market appreciation).

Unprecedented times just seem to keep coming and ‘normal’ market conditions seem to be in the rear view mirror. Portfolio managers are under pressure more than ever (and dealing with trends and conditions not seen before) and Boards’ jobs are not getting easier. Discussions, sharing of ideas, and camaraderie amongst Trustees, management, investment staff, and counsel continues to be more than vital. This is no time for anyone in the management and oversight models to horde information, act righteously, or go rogue. I firmly believe that pooling ideas, knowledge, and common goals and strategies are the model for success.

I wish everyone success navigating today’s social, economic conditions and anomalous climate.

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The Upcoming Elections, Volatility – Trustee Inquiries
(September 2020)

The year 2020 is not an easy time to be a portfolio manager or a security analyst. We are living in chaotic times laden with a pesky virus. Perhaps obvious to many, the Presidential election and Senate contests in early November present some unique challenges for everyone in the investment management business including Boards of Trustees. Candidates’ starkly opposing views on domestic affairs and policy, approach to and persistence of COVID-19, the potential for a contested election, markets arguably driven by only a few sectors, a shaky recovery etc. do not provide clear direction for those in a position to invest on behalf of shareholders. After the virus and election ‘smoke’ clears, a gargantuan chasm could exist between winners and losers.

What is a Trustee to do during these unprecedented times? In a nutshell: more questions and discussions, and fewer assumptions. Dig. Question. Dig some more. Ask for supplemental data, as needed. Trust, but verify. I would argue that Boards should probe even more diligently to obtain some comfort with how their advisor is dealing with any and all current events – whether highly likely or a black swan – that could impact security prices materially. Understanding an advisor’s positions, actions which are in line with prior buys/sells (or not), and current market philosophies should be on a Board’s agenda regularly, especially when pivotal events – such as an election, COVID vaccine(s), and an uncertain economic stimulus package – could dramatically alter the markets’ landscapes. To be clear, this information collection process is not to ensure advisor alignment with the Trustees, but simply to validate that an advisor has incorporated any and all applicable, material current events into the investment process. Frankly, Trustee insights and viewpoints through rigorous discussions with an advisor could deepen the methods by which securities are selected.

Some questions that could be posed to an advisor facing continued market turbulence, an upcoming election, and a dragging economic recovery:

What has history generally taught us about election years and the periods leading up to the November voting? What is anomalous about 2020?
How will each specific market react to a Trump victory vs. Biden? How might investment personnel configure portfolios for either scenario?
What if the Presidential voting results are contested? Is likely market volatility unavoidable?
Do you feel that a significant broad market correction is possible during the post-election period?
How does social unrest and the BLM movement figure into the investment process, if at all?
If the Senate moves from a Republican to a Democratic majority, what implications are likely for markets?
In what ways, if any, has your investment management process been altered due to COVID, the upcoming elections, Fed/Treasury stimuli and the like?
What types of industries are expected to rebound and/or thrive with a continuation of the Trump administration and which may enjoy continued or renewed interest under Biden?
How does the “race to formulate a safe COVID vaccine” impact your investment process and security selections, if at all?
If yet another stimulus package is ratified, how will markets react? Does this event present opportunities for certain funds?
How might the continued tilting of SCOTUS towards a more conservative stance move the markets?
What do your portfolio managers view as the factors most prominent in moving security prices over the next 4 months?
Up until then, how might certain types of equity or bond purchases and hedges – presumably being considered – benefit fund shareholders?

[This is clearly not an exhaustive list for all Boards, but hits many of the core issues. The objective is not specifics and targeted actions, but advisor thought processes and insights. Trustees are advised to consult counsel for other potential topics of discussion, if not already surfaced.]

In my view, one of Boards’ core functions is to thoroughly understand an advisor’s core investing philosophies, the level of resources dedicated to executing those beliefs, and generally how an advisor oversees and conducts their investment management operations. This year’s unique conditions have beckoned for flexibility and creative solutions that may not have previously been woven into the advisor’s cultural fabric. 2020 has clearly not been ‘normal’ from many angles, so new tactics and perspectives on the markets likely have surfaced. Trustees should understand what has changed and why or be afforded comfort that “staying the course” is prudent.

One again, stay healthy and wear your masks everyone.

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COVID-19 and Advisors’ Operational Challenges, Responses
(March 2020)

The novel coronavirus has significantly altered all of our lives for the foreseeable future. Many businesses have been temporarily shuttered, and most others have slowed in some ways, but not stopped. Travel has been significantly curtailed. Face-to-face meetings are (prudently) not occurring. Vacations have been cancelled. Full quarantines and stay-at-home orders are common. Many of our lives are on hold in an attempt to prevent the perpetuation of the COVID-19 pandemic. Clearly, financial services firms cannot “shelter” in any material way, have been granted exemptions from state shuttering mandates, and must remain prepared to creatively meet their clients’ needs during this tumultuous time.

What does this mean for fund Trustees? In my opinion, the following are a few new considerations that should be on the boardroom table. First, many Trustees will see fit to cancel in-person meetings and meet virtually. The SEC has made this possible with revised exemptions to the in-person regulations and their revised guidelines issued in 2019. In the near-term and as feasible, Boards are advised to meet virtually via teleconference and avoid possible infection. Communication with counsel is advised. Second, fund advisors are scrambling to keep operations at near-full capacity, primarily remotely, and with the staff who are able to conduct their jobs in the manner(s) to which they are accustomed and under likely duress. Boards should understand what new operational, portfolio management, and remote work issues are arising under this virus spread and ‘business hunkering’ scenario.

Lastly, most importantly, and given the unprecedented situation we all find ourselves in, what targeted questions should Trustees be posing to their funds’ advisor (if not already addressed voluntarily) which will provide them comfort that their investment management businesses will remain stable, brands are not damaged, investors receive ample communication, and firms retain financial viability? Simply put, without comprehensive updates on businesses now subjected to COVID-19 it would be difficult for Trustees to fully apply their business judgment and be diligent watchdogs. Now is not the time to simply let the advisor deal with the crisis as they see fit and take a “we trust management” perspective. These are anomalous times. I would argue that not acting inquisitively is not sufficient and will place Trustees in a difficult position in the event an advisor’s operations go south with superficial or minimal Board communications.

What are some appropriate, vital questions that should be addressed by advisors – in regular updates to the Board – to keep Trustees current on market developments, operational stresses, investor reactions, change in policies, and unforeseen issues? Some questions, topical considerations:

Investment Management

How are the various markets reacting to the coronavirus?
How are portfolio managers dealing with the increased volatility?
How have funds’ approaches to their objectives shifted as a result of the market turmoil?
In light of the NYSE floor closing, how have security trading processes changed?
What are the market outlook(s)? What catalysts will shift projections?
Is liquidity in some security holdings presenting challenges for funds?
Are valuation processes holding up under presumed stress? If not, what measures have been taken to ensure solid NAVs?
Has the liquidity “bucketing” process been compromised?
Are any money market funds in danger of “breaking the buck?”
What shareholder communications have taken place, if any?
Are fund outflows causing portfolio stresses? Credit facilities tapped?
Does the advisor understand and is adhering to state-specific mandates related to COVID-19?
Are the financial services business exemptions clear to the decision makers?

Operations

Have all personnel received one clear, definitive message from one source on how to approach their jobs, remote system access, internal communications and the like under the COVID-19 restrictions and precautions?
In what ways is senior management providing definitive paths forward and leadership?
How is your advisor managing operational risks not experienced previously?
Are most employees working from home? If not, why?
Is your advisor appropriately demonstrating a balance of corporate interests/financial health and employees’ health and welfare?
Have levels, speed or quality of remote connectivity compromised services in any way?
What operational processes worked under stress? Which did not and how have they changed?
What is the plan to provide a regular status report to the Trustees?
Have contingency and business continuity/back-up plans worked as anticipated?
Have the market conditions and COVID-19 adversely impacted employee morale?

Remote work, Outside Providers

Are remote systems adequate for everyone (and while simultaneously utilizing)?
Does the firm have increased cybersecurity risks from remote system access?
If so, what processes or new software are being deployed to mitigate the risks?
What are the stresses on the funds’ third-party providers?
What actions have third parties taken in an effort to sidestep timing issues, data errors, service quality deterioration and the like?
Indeed, have service issues or materials errors arisen? Please detail, as necessary.

[This is arguably not an exhaustive list for all Boards, so unique advisor/complex situations will drive counsel advice and the Trustees’ business judgement(s).]

Undoubtedly, we all hope that the world gets the coronavirus under control in the very near future and that hospitalizations and fatalities are kept to a bare minimum. And, we all sincerely thank the medical professionals and volunteers who are working tirelessly to test, treat, and care for, those infected or feel they should be hospitalized. These are scary times from a health, social, and financial standpoint.

In light of the current, unprecedented conditions, Trustees need to be prepared to act even more diligently – albeit remotely – and be the vital watchdogs the ’40 Act intended them to be. Your concerns, probing questions, and collective business expertise may be crucial in helping your advisor to weather this storm.

Stay healthy, everyone.

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Advisor Cost Cutting and the Specter of Potential Mergers
(January 2020)

The reality of negative net flows for a substantial quantity of active mutual funds has arguably spurred additional financial pressure on many fund complexes since index products’ popularity have taken hold. To no industry observer’s surprise, many fund sponsors have scrambled to negate the effects of shrinking assets and thus, advisory fee revenue. Counteracting the financial fallout from lower fund assets is no simple task and is not without risk. Boards should seek to understand in what ways advisors may be cutting operational costs to maintain margins or simply retain financial viability. A fiscally healthy advisor is key, but shedding some operational weight may have unintended consequences.

What are acceptable ways for fund advisors to cut costs, potentially maintain profit margins, and not compromise shareholder service quality or scope? For instance, is it acceptable to cut compliance resources during a period when demands on staff appear to not be waning? Based on the time period since the 2008/2009 market meltdown, the most widely used method across financial services to cut costs appears to be staff reductions. While this approach may – many times – achieve monetary goals, enterprise fallout may not be evident until operational holes appear, reputational damage has been incurred, and repairs may be painful and drawn out.

For reasons such as unfounded enthusiasm or optimism on the part of an advisor, this fallout may neither be sufficiently anticipated nor be mitigated swiftly enough. What is a Trustee to do? The Board must get comfortable that staff cuts are palatable due to these factors, amongst others:

Changes to investment management approach which requires less manpower
Operational efficiency gains
Employment of new technologies
Outsourcing was utilized, e.g., trading, transfer agency etc.
Staff redundancies were supposedly uncovered

Or, perhaps most obvious, a precipitous drop in fund assets truly requires less personnel to support fewer shareholders. In my view, the Trustees, when asked “Do you still have the resources to maintain shareholder returns and service quality?” should not be satisfied with a simple “Yes, we have sufficient resources.” Some diligent Board probing to attain details, metrics, examples etc. is certainly preferred and builds a stronger record in the event that staff reductions are significant.

With assets plummeting for some complexes, the second and possibly more likely scenario is a fund advisor entertaining a merger with a like-sized entity or selling their book of business to a larger competitor. Such a business proposition should facilitate more Board involvement and communication with their funds’ advisor, but not prompt direct involvement in the business decisions. Mutual fund Boards were never intended to play a managerial/operational role, but primarily oversee business structures, regulatory adherence, fund contracts’ appropriateness and reasonableness, shareholder welfare and the like. Perhaps it goes without saying that advisors should always make their intention to merge with another complex or be acquired known to a fund Board, essentially “front-running” the anticipated transaction.

In my opinion and given a pending transaction, Trustee questions akin to “What is your thinking on X topic?” and “What do you anticipate your approach to Y will be?” and “What timelines might we expect for the proposed business transaction(s)?” are appropriate. Some more specific Board questions related to a complex merger or acquisition could include:

What operational synergies do you envision being created with the other complex?
Which funds will merge away, survive? Why?
What are the anticipated pro forma impact on each fund’s expenses, if any?
Which portfolio managers will be retained to manage surviving funds?
How might some funds’ investment objectives or approaches be modified?
How might investor liquidations be mitigated upon announcement of a transaction?
Which service provider entity contracts will survive any merger(s)?
How might any merger or acquisition benefit current shareholders?
What business tactics have been employed to avoid a supposedly unavoidable acquisition?

[This is clearly not an exhaustive list, but serves to highlight some core issues.]

Boards of Trustees are strongly encouraged to engage and routinely use counsel during the process to obtain background on any transactions, ask the “right” questions, and fully understand shareholder impact of any advisor change in ownership decisions. Trustee focus should be on attaining sufficient knowledge and comfort that your business judgment may be adequately applied in approving any business sale or combination and related surviving business structures.

The “active” side of the business is currently under relentless pressure to perform, attract shareholder interest, compete with their “passive” constituents, and stay relevant. Yet, investor whims are not uncommon (!) as is the ability for active managers to outperform bogeys. One can argue that active strategies have not become outdated, but some contraction of the business may occur as a natural part of business evolution – fund liquidations, complex mergers and advisor acquisitions are probably imminent.

As always, Trustees need to be prepared to act diligently and prudently.

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Management Fee & Expense Decreases – A Plethora of Board Decisions, Options
(September 2019)

With passive index funds and ETFs garnering continued marketplace interest – primarily due to their cost advantage – active funds’ total expense ratios are clearly being more closely scrutinized by investors and intermediaries. Thus, many Boards and advisors are agonizing over the continued reasonableness, appropriateness, and competitiveness of their funds’ management fees and total expense ratios. Clearly this exercise is, and has been, integral to the 15(c) process, but the landscape has changed. From my vantage point and given the dearth of flows, a not insignificant amount of fund Boards are pondering (generally targeted and modest) management fee or total expense ratio decreases to narrow the spread with their indexed brethren.

Virtually all Trustees are acutely aware that a wide variety of active funds are struggling to attract new shareholder monies as passive has gained substantial distributor and investor favor. As active fund performance results ebb and flow compared to market indices, relative cost bubbles to the surface as a core issue. Research from fund trackers, most prominently Morningstar, has put fund expense ratios in the crosshairs as a primary driving factor in bottom-line (relative) return results. They claim higher-expense funds consistently underperform and have published data to support their conclusion. Publicity of such findings and the widespread support for indexed products are trends that should not be ignored by mutual fund Boards and rightfully precipitate vigorous discussions.

Therefore, issues such as “Are we still competitively priced?” and “What level of fees will ensure continued investor and distribution channel support and interest?” have recently taken center stage on many boardroom tables, the inquiries now placed in different context. The marketplace has shifted – temporarily or otherwise – and strategy, pricing, and decisions should reflect the new attitudes. In the interest of clarity, this is not to say that actively managed fund products should now be priced at levels now common to currently-in-favor indexed funds. Active funds require much more operational infrastructure support, data research, investigative efforts, and dedicated personnel – they should continue to be priced to account for these costs.

From my standpoint, some of the core issues are: 1) the pricing premia tolerance level for active investors (vs. passive); 2) the extent to which a fund’s expense ratio may truly compromises its net returns; 3) relative ratio competitiveness; 4) investor goals; 5) the current total expense ratio’s appeal on the desired platforms (or be screened out); and 6) the likely impact of renewed cost focus on a Board’s 15(c) process. Perhaps it goes without saying that, as Boards may embrace lower active fund fee levels, benchmarks tend to drop and cost effects ripple through many fund types.

Given the rise of indexed products and more scrutiny on cost, a good starting place for Trustees would be to ask the following questions. What is the Board trying to accomplish by working with management to potentially lower fees or expenses? How might this impact our advisor’s financial health, wherewithal, and shareholder value? To what extent must fees or expenses be lowered to truly create competitive advantage, elevate performance rank (as feasible), and potentially have an impact on marketplace or intermediary appeal? As a Trustee (and working with management), what may be some pricing, structural or strategic options available to reduce shareholder cost?

There are clearly several methods to achieve reductions to total operating expense levels incurred by fund shareholders or ensure competitiveness on an on-going basis. The primary methods are:

Contractual advisory and/or administrative fee reduction
Total expense ratio cap
Waiver to advisory and/or administrative fees
Routinely using a third-party provider fund expense benchmark(s) or custom benchmarks tied to distribution factors to assess competitiveness and adjust caps or ratios, as feasible

[Note: this can be undertaken annually during the 15(c) process or on an interim basis]

Each strategy to keep management fees and/or total expense levels ‘in line’ have upsides and downsides such as permanence or flexibility, some level of control over margins by an advisor (or not), clarity on total cost for shareholders, on-going adjustments with market movements and the like. It is advisable to consider all options’ positives and negatives when trying to assess any proactive changes to shareholder cost.

The simple fact that other fund shops are examining or lowering shareholder costs for some or all products should not categorically mean that all sponsors should be following suit. There are business model considerations that Boards should factor into their oversight. Solid reasons behind serious fee or expense decrease discussions are vital. If nothing else, citing the obvious price pressures today, and assuming presumably shifting benchmarks, should a Board not at least ponder the question “Have our fee or expense competitiveness been compromised in any material ways and should we be considering tweaking them to maintain our desired market position?” Perhaps most pertinent, management should have a thorough, well-informed, and cogent response to such a Board inquiry.

Fund Boards and advisors are well-advised to, at the very least, jointly consider the marketplace and investor impact of passive index funds’ pricing and appeal. Trustees should arguably have rigorous, on-going discussions with their funds’ advisor about distribution impact, marketplace pricing attitudes, and possible courses of action to counteract ‘soft flows.’ It is very likely that some level of strategic repositioning by much of the active management funds business is necessary to ensure its health within the retail, institutional, and defined contribution marketplaces.

Maintaining the status quo may not resonate with investors and a heightened focus on index-besting performance won’t hurt!

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ESG Funds – Renewed Interest, Elevated Board Oversight
(August 2019)

So-called “ESG funds” (an acronym standing for environmental, social and governance) have been building momentum lately, arguably garnering more investor interest than when they first debuted several decades ago as “socially conscious funds.” The increased flows could be due to general concerns regarding the environment, global warming, a move towards more socially conscious behavior, or a newly formed fundamental belief that those “funds that do good will do better” (financially). Likely, the recent flow success of ESG funds is a combination of the aforementioned factors and has garnered the attention of more fund sponsors.

Intra-category performance amongst similar funds (not accounting for ESG criteria) has been mixed since ESG funds entered the marketplace in the 1990s and shareholder dollar flows were generally modest. Historically dominated by a handful of firms, e.g., Calvert, Domini, PAX World etc., the ESG fund world has recently been breached by a larger number of sponsors – seemingly regardless of possible return implications – seeking to examine investor appetite for investment in companies which are conscious of all issues ESG-related. Investor interest has likely not yet hit a plateau, the guesses as to peak interest levels vary, and the “stickiness” of assets when relative performance could wane under certain market conditions is an open question.

A number of vital questions surround the ESG fund offering puzzle for Board and advisor such as:

The indicators that ESG is an unwavering trend and not just a current fad - ?
What do typical ESG investors respond to and thus, how are the funds marketed?
What specific, corporate ESG principles and/or criteria are acceptable when making (screened) investments and will this hamper portfolio management?
What types of shareholder disclosures appropriately (and legally) accompany this new genre of fund?
What does Board education and reporting look like?
What are the issues integral to ESG investing such as community impact, human rights, potential water taint, greenhouse gases and the like that should rightfully be considered by an advisor?
How do the new Sustainability Accounting Standards Board (SASB) ESG standards (voluntary compliance) play into product design, fund management process, and Board oversight?
Active or passive fund?
Should funds’ pricing potentially involve some level of premia given the extra layer of due diligence and cost for ESG screening?
What ESG investing (and psychological) benefits can be cited such that potential investors’ interest will pique and be retained through all market cycles?

These questions are undoubtedly not easily answered.

With adoption of the SASB standards being voluntary and thus, regretfully precipitating inconsistent disclosures, the core issue of ESG’s precise definition and direct comparability amongst issuers’ social resolve persists. Additionally, available data on the level and types of supposed corporate ESG adherence can vary widely. Extensive, internal advisor research is advised to reconcile data inconsistencies. As with prior funds held out as “socially conscious”, applied ESG criteria can be very strict or can be somewhat lax leading to more portfolio flexibility, but potentially misled shareholders. Advisors and Boards alike should be clear on how committed the product (and the investment manager) is to a set of strict social, environmental, governance etc. standards which mirror the intended mission of this genre. Yet, if for investment management reasons, a fund’s ESG criteria are selective or targeted, disclosures should be candid, thorough, and accurately characterize the product (roughly speaking) as only “considering the SASB standards, but product development did not incorporate every risk guideline.”

It is advisable to tread into, and oversee, this product space with vigorous research, moral intent, and an understanding that these types of products are hardly plain vanilla. All interested groups in this fund oversight model can expect to undertake highly elevated due diligence if success is to be achieved. Perhaps heightened environmental and social concerns in today’s world will support and propel these investments’ investment returns and shareholder flows over the long-term.

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Zero-Fee Index Funds – The Floor is Now Occupied
(October 2018)

The so-called “race to the bottom” for indexed mutual funds is over.   Move over Vanguard, Blackrock, T. Rowe, Schwab and TIAA/CREF. With the launch of 4 new indexed, equity mutual funds, Fidelity has reached the no-fee floor. The four funds carry the anticipated 0% expense ratio. No investment advisory fee and no other operating expenses are borne by investors in these recently introduced mutual funds. The funds are only available to Fidelity’s advisory clients who undoubtedly pay asset-based account management fees, thus they are not totally cost-free.

One can only presume that Fidelity is trying to attract new investors to its suite of investment management and other financial services with the zero-fee concept as a novel hook. The Boston-based funds giant can arguably use such an asset-gathering tactic with little or no return-at-outset given their scale, solid brand, financial wherewithal, and client scope. Will other investment company behemoths or even modest-sized sponsors immediately follow suit? Few, if any, would be my guess.

The introduction of funds with permanent, contractual advisory fees of zero arguably precipitates some quandaries and challenges for fund Trustees. Does this mean that all index funds ‘should’ be loss leaders and now be priced to equal the zero-fee floor? Should other index funds that carry some level of fee be forced by Boards to significantly cut their fees? Is a zero-fee strategy sustainable through eventual up- or cross-selling? Will the advisory contract renewal (“15(c)”) exercise be reduced to a “no fee, no discussion necessary” format? Do the smaller index players truly compete against the largest players in the passive space such that defining a “competitive universe” may be inherently subjective and problematic? These are no easy answers to these questions, yet let me offer a few thoughts to the raised, aforementioned issues.

First, not all index funds should now – like lemmings – follow Fidelity blindly to the rock bottom rate. The decision to offer similarly priced funds should be complex-by-complex, may be determined by scale and operational wherewithal, depend on the type of index fund, and be driven by client tolerance and demand. The Board should be involved and have input.

Second, one can arguably make the case that that those index funds with little or no total expense ratio put tremendous pressure on existing, identical offerings to charge very modest fees since expenses essentially determine much of the bottom line return and competitiveness. Again, how deep the cuts may be will likely be driven by scale, client base, operational structure, and perhaps by realized margins (or lack thereof).

Third, the underlying hypothesis that client assets in no-fee funds can eventually be converted into more profitable accounts through alternative product placement has yet to be proven. While the Fidelity funds have already garnered significant assets to date, that success is only stage one of the road to higher margins. Some industry participants may view this strategy by Fidelity as a ‘test balloon’, so all will be watching its flight pattern and altitude.

Fourth, I believe it would be dangerous to, for all practical purposes, rubber-stamp the renewal of the advisory contract for all such products given their zero fees. While relative operating expense levels are core to the 15(c) process, these costs are certainly not the only factor that Boards must consider when renewing an advisory contract. As any long-time Trustee is aware, the Gartenberg factors are still very much applicable and cover a wide range of additional considerations. I am confident that Board counsel will have strong views on this subject – consult him/her.

Lastly, seeking to identify true “marketplace competitors” and all distribution channel participants can be elusive and ever-changing. Furthermore, the philosophy that cost, i.e., the expense ratio, is a large factor in fund selection can be debated. The cheapest funds do not always win. Service quality, brand, investment models, return consistency, disclosures, support etc. all count. Arguably, everyone does not compete against everyone else. It seems unwise for Boards of smaller complexes to examine only a small section of the industry when comparing fees as the largest fund companies are competitors in one form or another. However, the Trustees have the ability to overlay their business judgement on the data and weight companies of similar wherewithal and scale higher, as applicable. A reasonable scope of industry data and wide considerations should be the goal to create a solid due diligence record.

The industry focus on index-tracking products continues … for now.

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Funds’ Reaction to the Recent Market Correction?
(February 2018)

As all readers are undoubtedly aware, last week was witness to – what some may argue was – a long-overdue market correction. And, we may not be done with stock value erosion. Equities were arguably overvalued and may still be a bit ‘rich.’ Corrections are a fact of investing as money flows rationally or irrationally into the market and then back out just as fast, in many cases.

The questions that arise for fund Boards are a matter of their funds’ reaction(s) to the market volatility, short-term uncertainty, and relentless gyrations. Not all domestically focused funds will have been impacted by the prices corrections similarly and some may have benefitted from the mercurial conditions by design. Most undoubtedly lost not significant value as widespread jitters hit many sectors, some with little discrimination.

Trustees should seize this period in market history to reflect on, and inquire about, a number of topics and probe with great interest about how their funds’ (and their advisor) reacted to the plunge in stock values. I would submit that the following ten questions (about appropriate domestic stock funds) be put on the boardroom table, if not already discussed or disclosed to the Trustees:

Did the funds behave holdings- and performance-wise as the Board would have expected?
If buffered market volatility is an objective of the fund, did the PM succeed in not following the market prices to every new trough?
Were derivative positions a factor (positively or negatively) in how the funds performed through the correction?
What was the fund investor base’s reaction to the (presumed) dip in performance?
Post-correction, what communication was or will be offered to investors, if any?
Through the correction, did the fund strictly follow its fundamental policies and investing parameters?
Did the fund stretch the bounds of typical investing techniques to which investors had been accustomed?
If some of the funds’ typical investing behaviors were tested, do any marketing materials now not accurately apply?
Did some of the “safer sectors” viewed as partially immune to large market dips drop more than anticipated? Why?
What lessons did the advisor learn during the recent market turmoil and/or how might investing approaches be modified in the future?

[This list is likely not exhaustive, but it surely is a good fundamental start to commence discussions amongst the Board and advisory personnel.]

Market ups and downs like those witnessed last week test the mettle of advisors and their products’ resilience from relative performance and investor sticktuitiveness standpoints. Most importantly, Boards should understand in a reasonable amount of detail likely advisor and fund reactions to traumatic market and world events and what they may mean for PM management strategies, future business plans, cash flows, investor communication, and overall advisor stability.

Stay tuned – the temporary carnage may not be over.

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Passive vs. Active
(October 2017)

Industry sponsors and Trustees alike have undoubtedly read about the flows enjoyed by sponsors of traditional indexed products and newer (indexed or index-based) ETFs. Their recent success has been the target of envy by fund complexes embracing active management exclusively. Investors seem to now be convinced that active managers cannot generally beat the market indices with any regularity. Yet, were there not prevalent examples of index-besting managers during the 2000-2002 and 2008/2009 corrections? Did these managers not retain investors’ assets more effectively than simply holding the index security basket? And, does history not bear out that active funds can outpace indexed products during periods of higher market volatility? In short, yes. Indexed does not always win.

While it’s true that necessary costs related to active portfolio management do put active managers at a disadvantage, “Bogle-ites” would have one believe that only less-informed investors stray from less expensive, index-hugging funds. The key to active management is clearly skillful and dedicated portfolio management and security selection algorithms or judgments that, with reasonable consistency, at least keep up with or exceed the market indicators. But, let me be clear, the higher cost hurdle still lingers and essentially raises the bar for the hard-working, highly intelligent people who make up the portfolio management ranks.

The issue of outflows from active funds has been on the boardroom table for quite a few years now due to the indexed fund ‘craze.’ Word of its demise has not yet been uttered! So, for those many fund complexes not abandoning support for the benefits of active management, fund advisors and Boards are well-advised to devise a plan to ensure that active management does not fall fully out of favor. So, what does that plan look like? First, targeting marketing efforts surely must be employed. Index funds are not a sole, comprehensive solution to all investing goals – the benefits of active management during market volatility and correction periods is undeniable. Second, given the cost advantage of passive, sponsors and Boards must be conscious of costs and their impact on net returns. Crippling total expense ratios can put amplified pressure on portfolio managers in less-than-optimal ways. Possible solutions, when cost is a limiting factor, may include temporary and/or conditional management fee waivers, expense reimbursements, more aggressive advisory fee breakpoints, total expense caps, and – for some funds – performance incentive (“fulcrum”) fee arrangements. Third, redesign and/or launch of new or existing products that incorporate numerous strategies, uncorrelated asset classes and appropriate derivative securities that buffer systemic market risk might help to highlight that “protecting the downside” can be very beneficial rather than riding an index fund to the trough. Lastly, wholesalers and other sales and marketing personnel need to educate their distribution and investor services partners about the upsides to active management and secure full engagement.

While the almost euphoric appeal of index funds is not, in and of itself, a negative trend, on a massive scale it arguably promotes the mispricing of assets/companies and adds inefficiencies to markets. A balance between the two styles could be the best compromise for markets and sponsors as well as investors. The virtues of active management should be ‘evangelized’ and – with any luck – index-besting results during future market cycles may bring skeptical investors back to the active fold with at least an appropriate portion of their assets. Many might argue that renewed flows into active funds will not happen without a penalizing correction (whereby active funds could shine) or diligent efforts by the companies to “tell the story” and build unwavering support for full-time, active portfolio management.

It behooves Boards and advisors to conduct rigorous discussions regarding how both sides of the fence (active and passive) might peacefully co-exist and both be successful at the asset derby.