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SEC Posts Economic Papers on Fund Governance

The SEC has published two staff economic papers for consideration by commenters in connection with its proposed amendments to the investment company governance provisions. The governance provisions would provide that investment companies that rely on certain of the Act's exemptive provisions must have boards in which 75% of the directors are independent and must have an independent chair. The SEC's Office of Economic Analysis found no statistically significant relationship between fund governance and performance. While such a relationship may exist, OEA explained that the limits of standard statistical methods fail to identify it.

The first memorandum addresses the factors affecting the probability that a statistical test will identify a relation if it exists. The second memorandum reviews the existing literature on independent mutual fund chairs and directors. The SEC has invited comments on any aspect of the two papers or on any other analyses that are available to provide a comprehensive record of the consequences of the provisions, if adopted.

OEA found that most studies that assessed the impact of chair independence on returns did not have sufficient power to reliably conclude whether a relation exists. Statistical power is defined as the probability that a statistical method will identify an effect or relation when the effect or relation exists. OEA said there are limitations on the data, even though there are over 8,400 mutual funds in the U.S. Fund governance is typically determined at the fund complex level, according to OEA, but many fund families have two boards with considerable overlap in directors. The data is also difficult to retrieve.

OEA noted that economic theory suggests that if there are no impediments to the markets working efficiently, mutual funds and their shareholders would select the optimal governance characteristics. There should be no expected relation between those characteristics and fund performance. OEA found a substantial degree of variability of asset returns that could not be explained by variability in other determinants of returns. A key question in its analysis of mutual fund governance was the appropriate method of measurement. OEA cautioned readers against reaching strong conclusions about the nature of the relation between independent fund chairs and performance based on the evidence that is currently available.

In examining the available literature relating to mutual fund governance, OEA drew two inferences. Boards with a greater proportion of independent directors are more likely to negotiate and approve lower fees, merge poorly performing funds more quickly or provide greater investor protection from late trading and market timing. Second, a broad cross-sectional analysis provides little consistent evidence that the board composition is related to lower fees and higher returns for shareholders. OEA acknowledged that these inferences may appear to conflict and offered several explanations.

First, OEA noted that there is no sound structural model through which researchers may isolate the effect of a board decision on performance from all of the other factors that may affect performance. The limits of the data and statistical tools may make it difficult to identify relations that exist and are economically significant. In addition, the nature of the conflicts of interest in mutual funds is such that there may not be a unique relation between governance and performance. OEA explained, for instance, that poor governance at times may lead to higher returns through excessive, nontransparent risk-taking by fund managers.

Economists have suggested that the management of conflicts may play a more central role for a mutual fund board than for an operating company board. Given the limited literature on fund governance, OEA also reviewed the governance literature for operating companies since it is more established. Based on the available literature, OEA concluded that boards with a greater proportion of independent directors are more likely to make decisions that may lead to higher returns. Second, there is no consistent evidence that chair or board independence is associated with lower fees and or higher returns for fund shareholders in the cross-section. OEA said its conclusions reflect the lack of a structural model and insufficient data.

Jacquelyn Lumb