by Cynthia Harrington

While CPAs are well-attuned to the modern portfolio theory of risk, poor fund governance has sounded a new note of potential danger.

The traditional risk of price volatility is joined by the risks of fund managers acting in ways that harm, not help, shareholders. Advisors are having to find ways to add the new understanding into the asset allocation process.

Advisors want to stay out of funds that might cause undue explanations to clients following the recent headline-grabbing behavior.

Conversely, new regulated disclosures reveal characteristics of funds that advisors want to favor. “The rules are coming fast and furious,” said Jeff Klein, executive manager of sales and marketing at H.D. Vest, in Irving, Texas. “From our firm’s perspective, disclosure is the most important thing, and we’re working with partners to encourage them to follow the best practices.”

The required disclosures give clients and their advisors more information about fees, manager compensation, board make-up and other conflicts of interest. But there might be various ways to state the required information. Klein suggested that his firm prefers that fund companies follow the spirit, rather than just the letter, of the law. An example of moving beyond the ordinary is the fund company that now reports individual client fees in each monthly statement. “We’re encouraged by the increased transparency,” said Klein. “Who clients are paying and how much is more visible now, and broker/dealers know much more about what the fund companies are about.”

The required facts will appear in each prospectus and will be freely available to advisors and investors. Investment professionals may find that interpreting the new fund disclosures becomes an edge for their clients.

Recent regulations prompted another important change at funds that individuals may overlook.

Information about the now-required independent compliance officer might yield important clues to the character of the fund’s management. “The chief compliance officer now reports directly to the funds’ trustees, making this role pivotal,” said Jeff Keil, vice president of global fiduciary review in the Denver office of Lipper, a Reuters company. “The characteristics of the CCO might reveal important clues to how serious the fund company is about good governance.”

Advisors might evaluate how candid the fund is about the new status of the CCO, and might want to favor funds that clearly reveal their policies and procedures regarding the new position, as well as having detailed checks and balances.

The background and qualifications of the person hired to do the job might also be an indication of the fund company’s commitment. The perfect candidate would have a legal background, and experience and training in fund accounting, as well as fairly detailed experience in the investment management process. “Of course, a lot of smaller groups don’t have a half million a year to pay this person,” said Keil.

Tracking and analyzing more information also means more time dedicated to due diligence. Reps at H.D. Vest have additional personnel at the broker/dealer level as well as at parent Wells Fargo combing through information. “Wells Fargo has designated a person there to help us,” says Klein. “And I’ve added the task of personally talking to all our 15 mutual fund partners every month. That’s an additional 15 hours of time, but that keeps the relationship open and I feel we get the straight scoop.”

Morningstar is stepping up to help advisors by adding a fiduciary grade to its fund evaluations. The new grade debuts on 500 of the largest funds. The mutual fund data provider expects to expand it to other funds in coming months. The fiduciary grade gives advisors an overall governance quality ranking according to what Morningstar defines as key variables. The grades run from the best grade of A to the worst of F, and judge the quality of a fund’s response to regulatory issues, the quality of its board, the efficiency of the managers’ incentives, the level of expenses and the desirability of the corporate culture.

“The newly required disclosures allow advisors to go beyond traditional risk and return evaluations,” said Kunal Kapoor, director of mutual fund analysis at Chicago-based Morningstar. “Advisors now have more tools to assess whether the fund managers’ interests are aligned with those of investors.”

Not all advisors find much to cheer about in the latest regulations. These rules solve past abuses, but clients’ faith has been shaken. “The new regs fight the last battle,” said Mark Balasa, CPA, CFP, of Balasa Dinverno & Foltz LLC, in Itasca, Ill. “At our firm, we’ve moved more and more to passively managed funds as a result.”

The new disclosures don’t answer the central question for Balasa. He’s happy to have easy access to a manager’s personal ownership in the funds and their compensation structure. He also seeks companies that are not sales-driven, meaning those without 12b-1 fees and with a history of closing funds that grow too big. But in the end, he said that advisors still need to know that they can trust the managers they’re placing client assets with.


“No one knew what to ask to catch the recent abuses, nor did we have to tools to discern what was going on,” said Balasa. “Besides, the Securities and Exchange Commission was watching their activities from the inside and they didn’t find it either.”

Those hopeful about the new disclosures expect them to change the fund industry. Investors and advisors will reward good governance with
increased assets. “Truth in labeling is important,” said Vest’s Klein. “These disclosures allow the advisor to help clients make decisions, which right the investor ultimately should own.”

Klein also pointed out that investors are getting more knowledgeable about fund choices. More investors are realizing, for instance, that a low expense ratio on a fund that doesn’t meet expectations isn’t of great value. He went on to explain, “Increasingly, investors are willing to pay for good advice. When all is said and done, the free market is going to help everybody decide the value of what they’re getting.”

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