Good Risk Governance Pays - Investment Best Practices | Risk Management | Valuation

Following the ruling in Gartenberg v. Merrill Lynch Asset Management, many people look to the six factors discussed therein in determining the reasonableness of fund fees. To recap, the Gartenberg factors are listed below:

• Nature and quality of services rendered;
• Profitability of fund to the advisor;
• Scale considerations that impact the cost of managing a fund;
• Fees charged by peer funds;
• Independence and thoroughness of the board; and
• "Fallout benefits" which indirectly accrue to the advisor because a particular fund exists.

Since no one wants to be in business unless they can earn a risk-adjusted return, it is no surprise that the profitability factor is given considerable weight by investment company directors and advisors alike. For those on the outside however, it is not always an easy task to evaluate any gains or losses realized by one or more invesment companies.

As explained in "Deciphering Fund Fees: Advisors need to understand when fund management fees are excessive" by Sasha Franger (onwallstreet, June 2012), one information source - Lipper's "Investment Management Profitability Analysis" - includes complete data for only public entities. This means that the report reflects data for "26 investment managers representing 23% of the mutual fund industry's assets." Other complexities include the following:

• Not all companies report marketing expenses as a separate item;
• Not all firms report "total revenue" in the same way;
• Some companies included in the study manage a broader array of funds in addition to mutual funds;
• Some companies included in the study offer other services in addition to asset management; and
• Revenue varies by type of funds that an investment company offers.

To better understand the structure and financial conditions for various funds, visit the website for the Investment Company Institute to download the 2012 Investment Company Fact Book: A Review of Trends and Activity in the U.S. Investment Company Industry.

Figure 5.2 shows that expense ratios typically fall as assets under management go up. Figure 5.6 shows a downward trend in expense ratios between 1997 and 2011 for active versus passive funds. Not surprisingly, expense ratios for actively managed equity funds are higher than index equity funds. Figure 5.7 shows that median expense ratios are highest for funds with growth, sector, international equity and aggressive growth investment objectives, respectively.

Given the preponderance of regulated investors such as ERISA pension plans that allocate to members of the $12.97 trillion mutual fund industry and the frequency and severity of 401(k) plan lawsuits that allege "excessive fees," investment company financials are being carefully watched and monitored.

Having worked on fee litigation matters, I would add that a parsing of numbers requires care for various reasons.

According to Shannon Barrett, attorney and partner in O'Melveny & Myers' ERISA litigation practice, new fee disclosure regulations could mean more lawsuits against record-keepers and other organizations that provide services to U.S retirement plans. Cited in "New Fee-Disclosure Regs Pose New Litigation Risks for Retirement Plan Providers" by Fran Lysiak (Insurance News Net, March 2, 2012), Barrett adds that new rules "will force record-keepers and similar service providers to 'stake a position on something that is a very disputed legal issue,' referring to fiduciary status.

For more information, check out "DOL Retirement Plan Fee and Expense Disclosure Compliance: Navigating New Rules for Service Providers and Plan Sponsors." Sponsored by Strafford Publications, this March 27, 2012 webinar will feature two senior ERISA legal experts with Morgan Lewis, Michael B. Richman and Daniel R. Kleinman, and will explain Section 408(b)(2) disclosure rules and what compliance (or lack thereof) means.

Transparency is a continued mantra with regulators and lawmakers in the United States and elswhere. In a recent conference in Washington, DC called "SEC Speaks," speakers from the U.S. Securities and Exchange Commission reiterated the need for robust disclosures to promote "fair and orderly markets."

Of course more disclosure does not always translate into better disclosure but certainly there are numerous best practices as to how numbers should be reflected to empower investors and plan participants with what they need to know. As I have said many times, numbers are helpful but certainly not the totality of the risk factors that should be considered with any vendor or asset manager relationship. The process of vetting economic, fiduciary and operational risks (among others) is a complex but hugely necessary expenditure of time and money.