There’s a Fund for That: Remarks before FINRA’s Certified Regulatory and Compliance Professional Dinner

Thank you, Professor Angel, for that kind introduction. I appreciate the opportunity to speak with you this evening, but first must remind you that I will be expressing my own views and not necessarily those of the Securities and Exchange Commission (“SEC”) or my fellow Commissioners.

With a few exceptions, I am not a big fan of smartphone apps. I am in a fight now, for example, with an annoying cell phone alarm app that is trying doggedly to put me on a sleep schedule. Keep it simple is my mantra. In fact, on my first smartphone, I managed to delete the app store entirely. The wireless store geeks had never seen anyone do that, and they could not figure out how to put it back on the phone when I found an app I wanted. I do find the human ingenuity behind apps remarkable, however. Whatever problem you are confronting, there’s usually an app for that![1]

Investment funds are similar to phone apps in their breadth and popularity: whatever your objectives, you will find a fund or a set of funds to serve them. Open-end funds allow investors—often at little cost—to pool their money, diversify their investments, receive professional money management, and sell their shares whenever they want. Since their launch nearly 100 years ago,[2] open-end funds have proliferated, and at the end of 2021 there were more than 10,000 mutual funds and exchange-traded funds in the United States with over $34 trillion in assets.[3] You can choose from equity funds, bond funds, index funds, sector funds, quant funds, faith-based funds, green funds, sin funds, and many more. While there may not be as many open-end funds in our marketplace as apps available to cell phone users, whatever want or need an investor is trying to address, there’s usually a fund for that!

As popular and well-established as funds are, a fundamental fact about them is misunderstood. This misconception about funds has even crept into our regulations, so I want to spend my time this evening talking about a rather pedestrian fact: each fund—whether it is a mutual fund, exchange-traded fund (“ETF”), closed-end fund, or hedge fund—is a unique entity with its own objectives. Funds are distinct from their investors, their asset managers, and the other funds in the same complex. Too often, however, funds’ interests are treated as being identical to those of their managers, their shareholders, their investors, or other funds in the same complex. Because of this, fund money, votes, voices, and choices about engagement are at risk. I will address each of these in turn, beginning with fund money.

1. Fund’s Money

When an investor chooses a fund, she thinks about how it will serve her interests given her own circumstances, risk appetite, and portfolio. Fund disclosures, prepared in accordance with rules promulgated under the Investment Company Act, help her make that choice. Among other things, fund disclosures provide information about the fund’s investment objective, fees and expenses, principal investment strategies, principal risks, performance, and management.[4] Once an investor has made her choice, her money is pooled with the money of other investors who have chosen to invest in the same fund.

Funds are usually part of a fund complex under the sponsorship of an asset manager. An individual or team manages each fund’s portfolio under the oversight of the fund’s board of directors. One board may serve all the funds in a complex.[5] Being part of the same fund complex and sharing a board of directors, however, does not change the fact that each fund is a distinct entity with its own shareholders, objectives, and strategy for achieving them. Sometimes these objectives and strategies conflict with one another. Just as you might have one app on your phone that helps you find the nearest bakery and another that helps you lose weight, you might have two funds in your investment portfolio with conflicting objectives. The portfolio manager is bound to carry out her fund’s objective without regard for what other funds in the same complex are doing. The bakery-finding app and the diet app can sit side-by-side on one person’s phone, each operating independently. So too can two funds with different, and even conflicting, objectives or strategies sit side-by-side in an investor’s portfolio—and they nevertheless must operate independently, each in a manner consistent with its objective and strategy.

Let us create a seasonally appropriate hypothetical fund complex managed by mega-asset manager Leaf Pile Asset Management. Leaf Pile offers four funds. The Passive Pumpkin Index Fund’s objective is to track the performance of a benchmark index of the 300 largest U.S. companies. It seeks to achieve this objective through a strategy of investing in the stocks that make up the index in the same proportion as the index weights them. The Scarecrow’s Select Tech Fund’s objective is maximum long-term growth of capital, which it seeks to achieve through a strategy of investing primarily in common stocks of technology companies believed to have the potential for growth. The Falling Leaf ESG Impact Fund’s objective is to generate long-term total return. As indicated by its name, the Falling Leaf ESG Impact Fund seeks to achieve this objective through a strategy of investing primarily in U.S. companies that contribute to affordable housing, living-wage jobs, public health, green energy, pollution remediation and prevention, and sustainable food and water. Finally, the Crisp Autumn Energy Fund’s objective is current income, with capital appreciation as a secondary objective. It seeks to achieve its objectives through a strategy of investing primarily in companies focused on oil and gas exploration and production.

An investor who buys into one of Leaf Pile’s fund offerings is pooling her money with other investors who signed up for the same objective and strategy. She must be able to trust that each fund will operate consistently with its disclosures. The Investment Company Act and the fiduciary duty applicable to fund boards and advisers facilitate this trust. That fiduciary duty runs to each fund as a whole, so the investor has no reason to expect the fund to cater to any objectives that she, or any other shareholder, individually may have that are out of sync with the fund’s objectives.[6]

All four of Leaf Pile Asset Management’s funds share a board, but both the asset manager and the board owe a fiduciary duty to each fund they serve. An adviser has to adopt the goals, objectives, or ends of the principal.[7] Each fund’s objective and disclosed strategy must guide the board and adviser in its actions with respect to that fund. Doing so may not be easy. In our hypothetical, Leaf Pile, as part of its own sustainability program, has signed on to the United Nation’s Principles for Responsible Investing (“UN PRI”).[8] Among other things, these principles require a signatory, when consistent with its fiduciary duty, to “incorporate ESG issues into investment analysis and decision-making processes.”[9] Leaf Pile may find that doing so is consistent with its fiduciary duty with respect to the Falling Leaf ESG Impact Fund, but not with respect to Crisp Autumn Energy Fund.

Less obviously, an adviser’s fiduciary duty does not run to individual fund shareholders. The portfolio manager of the Scarecrow’s Select Tech Fund manages that fund’s portfolio without regard for individual shareholders’ idiosyncratic interests. An individual fund shareholder that works for a big tech company might not want the fund to buy shares in that company as it would increase her exposure to the company. Another shareholder might like to sell to the fund shares of a tanking technology company he holds elsewhere in his portfolio to dump his losses on the fund. The Scarecrow’s Select Tech Fund’s portfolio manager has to look out for the fund’s interests, which run contrary to the unique interests of these two fund shareholders. The Scarecrow’s Select Tech Fund is the client to whom the fiduciary duty flows. Once an investor puts money into a fund, she owns a piece of the fund, but her money belongs to the fund, and the fund’s adviser must invest according to the fund’s stated objectives.

The Commission has explained the “key difference between clients of investment advisers and investors in investment companies” this way:

A client of an investment adviser typically is provided with individualized advice that is based on the client’s financial situation and investment objectives. In contrast, the investment adviser of an investment company need not consider the individual needs of the company’s shareholders when making investment decisions, and thus has no obligation to ensure that each security purchased for the company’s portfolio is an appropriate investment for each shareholder.[10]

The Commission itself sometimes needs to be reminded of the distinction between fund investors and clients of an investment adviser. In 2004, for example, the Commission adopted a rule that would treat hedge fund investors as clients of the adviser for purposes of assessing whether the adviser needed to register with the SEC.[11] The D.C. Circuit Court of Appeals vacated the rule because it departed from the basic principle that an adviser cannot owe a fiduciary duty to both the fund and its investors without impossible conflicts arising.[12]

2. Fund’s Vote

This fundamental principle—that asset managers and boards of directors owe fiduciary duties to each distinct fund—has important consequence for our next topic of discussion: fund voting. Some asset managers, seemingly forgetting that funds are separate entities with unique interests, treat funds as an extension of themselves or as one with all the other funds they manage. Fund voting is an area in which this confusion manifests itself; fund votes sometimes betray a puzzling uniformity despite funds’ varied objectives and strategies. Just as with investment decisions, fund voting decisions must be guided by the fund’s best interests as assessed in relation to each fund’s objective and strategy.

Funds have to decide whether and how to vote with respect to many matters at each of the fund’s portfolio companies. A fund may choose to exercise, or not exercise, its voting power, but that choice—and the choice of how to vote—belongs to the specific fund that holds the securities to which the vote is attached. The exercise (or non-exercise) of a fund’s vote should serve the interests of that fund and that fund alone. The board is responsible for voting, but the adviser typically makes the voting decision, sometimes with the input of a third party such as a proxy adviser.[13]

Rhetoric and action by advisers and their regulators do not always reflect that votes must be in the best interest of each particular fund. In a recent rulemaking on proxy voting by funds, for example, the Commission stated, without acknowledging the potential conflict between the two interests, that “fund advisers are subject to fiduciary duties and thus must make voting determinations in the best interest of the fund and its shareholders.”[14] Advisers’ voting guidelines or policies, at times, refer to “our vote,” which suggests that funds’ votes are an asset for the adviser to control for its own purposes. Voting practices by funds sometimes seem inconsistent with a fund-focused best interest analysis.[15] An adviser may be tempted to vote to further the interests of someone other than the fund on whose behalf it purportedly is voting, including itself. The Commission laid out a potential scenario in which the adviser might benefit from voting a fund’s proxies a particular way: “when a fund’s adviser also manages or seeks to manage the retirement plan assets of a company whose securities are held by the fund . . . a fund’s adviser may have an incentive to support management recommendations to further its business interests.”[16] In these and similar instances, a fund’s votes may reflect the adviser’s desire to gain new business rather than the fund’s best interest.

Third-parties, with an interest in the outcome of a vote, might try to pressure advisers into voting the shares of funds in a particular way. Some organizations successfully target asset managers and ask that the firms commit to use the resources under their control to achieve non-investment goals such as cutting global carbon emissions, halting the loss of biodiversity, and overseeing portfolio companies’ political engagement.[17] The objectives of these pledges may match the objectives of some funds, yet sometimes the pledge is a pledge to manage all assets in accord with the third-party organization’s principles. Of course, merely signing on to a third-party’s pledge does not mean an adviser has cast off its fund-specific fiduciary duty. But if Leaf Pile Asset Management has made such pledges, one must ask: does it consider its commitment to these pledges when casting a vote on behalf of the Crisp Autumn Energy Fund, which is required by its own fund objectives and strategies to invest in oil and gas? Leaf Pile could compromise its own ESG ratings if it does not comply with its ESG pledge commitments in votes by all four of its funds, but adhering to the pledge could set Leaf Pile at odds with its fiduciary duty to a particular fund.

The Commission has recognized the many potential interests at play in fund voting, but has taken a flawed approach that over-emphasizes voting to address them. In 2003, the Commission announced that “the time has now arrived for the Commission to require mutual funds to disclose their proxy voting policies and procedures, and their actual voting records.”[18] The adopting release explained that:

Proxy voting decisions by funds can play an important role in maximizing the value of the funds’ investments . . . . Further, shedding light on mutual fund proxy voting could illuminate potential conflicts of interest and discourage voting that is inconsistent with fund shareholders’ best interests. [Note the concern for fund shareholders’ interests rather than fund interests.] Finally, requiring greater transparency of proxy voting by funds may encourage funds to become more engaged in corporate governance of issuers held in their portfolios, which may benefit all investors and not just fund shareholders.[19]

Earlier this month, the Commission added to the 2003 requirements by requiring funds to categorize their votes, present them in machine-readable language, and disclose the number of shares loaned but not recalled and, therefore, not voted by the fund.[20]

The requirement to disclose how a fund votes can facilitate assessments of whether the fund’s votes match its objectives. If the Passive Pumpkin Index Fund is voting in favor of shareholder proposals calling for companies to build affordable housing for employees, cut greenhouse gas emissions, or link executive pay to social metrics, a fund shareholder would be able to see that her purportedly passive fund might have an activist bent. By contrast, if a shareholder in the Falling Leaf ESG Impact Fund saw that the fund was voting in favor of those proposals, she might be reassured that her fund is behaving as it said it would. So fund vote disclosures theoretically can serve a positive role in ensuring that funds’ votes are consistent with the fund’s objectives and strategies. Practically speaking, however, fund shareholders might not peruse granular voting disclosure,[21] but a voting disclosure mandate might empower other parties who are interested in commandeering the votes for their own purposes.

Whether they want disclosure or not, fund shareholders will have to pay for mandatory disclosure of votes. For many funds, the cost of disclosing every vote likely outweighs the benefit. Understanding the general approach to voting might be sufficient for shareholders in the Scarecrow’s Tech Picks Fund, whereas shareholders in the Falling Leaf ESG Impact Fund might want to know every vote. For some funds, making a voting decision on every proxy voting item for every portfolio company does not make sense. Voting comes with costs for proxy research, proxy advisory firm assistance with execution, and overseeing those services.

Requiring every fund to disclose its votes implicitly pressures funds to vote, even when voting is not in their best interest. A determination not to vote or always to vote in line with management might be the best approach, particularly for cost-conscious index funds. Indeed, as Professor Stephen Bainbridge has explained, expense-minimizing index funds have no reason to spend a lot on voting.[22] The Commission acknowledged recently that an adviser could agree with its fund client not to vote when “voting would impose costs on the client, such as opportunity costs for the client resulting from restricting the use of securities for lending in order to preserve the right to vote,” to vote only on certain consequential matters, or not to vote “on certain types of matters where the cost of voting would be high, or the benefit to the client would be low.”[23] The Scarecrow’s Select Tech Fund, for example, has an objective of maximum long-term growth, and the portfolio manager lends portfolio securities to generate additional income.[24] Except on matters like mergers and acquisitions, the cost of voting outweighs the benefit to the fund. Now, however, pressured by the requirement to disclose how many shares were not recalled for voting, the portfolio manager may forgo the securities lending revenue and undertake the expense to vote on the full range of issues.

The rule’s nudge effect is amplified because it serves as a monitoring mechanism for organizations to which an asset manager has pledged to vote the shares of the funds it manages in a particular way. For example, if Leaf Pile Asset Management signed on to the Asset Managers Net Zero Initiative, it would agree to “Implement a stewardship and engagement strategy, with a clear escalation and voting policy, that is consistent with our ambition for all assets under management to achieve net zero emissions by 2050 or sooner.”[25] The requirement for all of Leaf Pile’s funds to disclose their votes will put the asset manager in the position of explaining to a third party why it voted the shares of only one of its four funds—the Falling Leaf ESG Impact Fund—in favor of proxy items designed to force companies to adopt net zero emissions policies.

Portfolio managers may face pressure from within the fund complex to vote a particular way. Asset managers often have one set of specialists to make voting recommendations to all the funds it manages and these funds often default to a single voting policy. Differences in strategies across funds, or different value judgments as to voting may be underappreciated. Individual funds’ portfolio managers must do extra work to buck the Leaf Pile Stewardship Hub, which is responsible for establishing default positions with respect to corporate governance and other proxy issues and developing voting recommendations on specific items for Leaf Pile Funds. A centralized process and default to uniformity deemphasize funds’ uniqueness, but amplify the adviser’s clout. For example, a portfolio company will pay a lot more attention to an adviser whose funds vote as a block.

3. Fund’s Voice

Along with voting power comes influence over portfolio companies—their voice in meetings with portfolio company management. The exercise of this influence is known euphemistically as “engagement.” Asset managers often meet with their funds’ portfolio companies to urge them to do or not do things. Companies, eager to win investors’ favor, are receptive to these meetings and often initiate them.

As with votes, however, an adviser is not engaging on its own behalf, but on behalf of its clients, meaning its funds (and any non-fund clients it has). Leaf Pile Asset Management’s clients are its four funds. These funds’ shares are Leaf Pile’s entry ticket into engagement meetings. Given the divergent objectives and strategies of the different funds, Leaf Pile may not be able to say much in meetings with a portfolio company in which it purports to represent all four funds. Complicating matters further is Leaf Pile’s status as a signatory of Climate Action 100+, which coordinates engagement on climate-related issues and requires that companies engaging on their own report to the broader group.[26]

How should Leaf Pile Asset Management approach discussions with any given portfolio company? For example, Falling Leaf ESG Impact Fund might want the engagement meetings to focus on whether and how the companies are working toward net zero targets. Crisp Autumn Energy Fund, by contrast, might insist that Leaf Pile not exert any pressure on those companies to set net-zero targets, but use the meeting instead to urge the company to lower operating expenses. Scarecrow’s Tech Picks Growth Fund might be more concerned with the companies’ acquisition plans than with anything related to net zero. In the case of Passive Pumpkin Index Fund, where investors have bought the fund for exposure to the underlying companies (and implicitly their management), the fund might view engagement between its adviser and any portfolio company—and any pressure on company management to make changes—as negative. How can one adviser, bound by its fiduciary duty to such diverse clients, speak with one voice? If a particular issue is important for one fund, will Leaf Pile intensify the message by not mentioning that some of its funds do not care about the issue or have a diametrically opposite view? “Stewardship” reports, which describe proactive engagement with portfolio companies, tend not to dwell on such fiduciary particulars.

Leaf Pile Asset Management, because of its own commitments and the interests of Falling Leaf ESG Impact Fund, might be tempted to walk into every portfolio company with the weight of the massive Passive Pumpkin Index Fund’s holdings as leverage for inducing the company to take steps toward net zero or achieve some other milestone of interest to the Falling Leaf ESG Impact Fund. The promise that Passive Pumpkin Index Fund votes will be withheld from directors if these steps are not taken will amplify either Leaf Pile’s or Falling Leaf’s voice. But is that promise in accord with Passive Pumpkin Index Fund’s own voice? As Professors Kahan and Rock explained, “a large index fund may increase the power of the portfolio managers of active funds in the same family in their interactions with portfolio companies.”[27]

Passive index funds raise unique problems for asset managers seeking to exercise their fiduciary duty. When a shareholder buys the Passive Pumpkin Index Fund, she wants exposure to the 300 companies in the index. She is not expecting, and may not want, the adviser to expend its efforts to change those companies. She would be justified in wondering how Leaf Pile’s decision to pursue an undisclosed activist voting and engagement strategy for this fund—whether on issues like executive compensation or the environment—is consistent with that passive strategy.

Some observers might respond that voting and engagement to maximize the value of portfolio companies in turn maximizes the value of the fund. But this raises other uncomfortable questions. For example, can Leaf Pile credibly argue that voting on all manner of contentious non-binding shareholder proposals has a link to value maximization at Passive Pumpkin Index Fund? The cost of activist voting and engagement may not make sense for that fund, which is marketed as a cheap way to get exposure to an index. Moreover, an activist voting and engagement strategy could turn Passive Pumpkin into an activist without any compass to guide its activism. If Leaf Pile plans to vote the fund’s shares and engage actively on Passive Pumpkin’s behalf with the goal of changing how companies are run, it ought to disclose that alongside the fund’s objective and strategy.

Advisers to passive index funds often assert that they must vote the fund’s shares in an active manner because the fund cannot vote with its feet and sell the companies in the index.[28] To match the performance of the index, index funds generally have to hold the companies in the index. Fund shareholders, however, can vote with their feet. They can sell their shares in the index fund whenever and for whatever reason they want. They can instead invest in a fund that is actively managed, tracks an index that includes only companies that adhere to ESG or other criteria, or explicitly offers a combination of index-tracking and activist engagement.

Boards and advisers of passive index funds face important decisions about their voting policies, but those decisions must be guided by their fiduciary duty to the fund and the fund alone. Whatever approach they choose, they must disclose it and adhere to it. A fund that was seeking to stick to its passive nature could not vote at all, vote according to the recommendation of the company’s management, or vote proportionately to all other shareholders of the company. Others favor “pass-through” voting, pursuant to which the fund seeks and follows guidance from fund shareholders. Essentially, this approach would allow shareholders, rather than the sometimes conflicted asset manager, to shape the fund’s voting strategy. Some interested third parties worry about pass-through voting because it would empower fund investors to override fund managers on ESG issues,[29] but that is the point if fund managers are voting fund shares to further their own interests, not those of the fund. Pass-through voting, if not designed to ensure broad shareholder participation, however, could empower a few activist shareholders whose interests are divergent from those of the fund to capture the fund’s vote for their own ends.[30]

Regardless of which voting approach a passive index fund’s board chooses, the fund’s disclosures should state whether the fund will vote and, if it does, what principles it will follow in doing so. While voting disclosures are usually not in the fund prospectus,[31] if the fund adopts a voting strategy that does not obviously align with the fund’s objective and principal strategy, highlighting it in the prospectus where the objective and principal strategy are described could help investors find funds that match their preferences. Passive funds with activist voting strategies would seem to fit in this category. Ensuring that a fund’s votes line up with its disclosures is not enough. The substance and frequency of engagement with public companies also need to line up with the disclosures and interests of the fund purportedly being represented in those meetings.

4. Conclusion

The bottom line is that we need to respect funds’ status as distinct entities, each of which serves investors in a specific way. Smartphone users expect each app on their phone to stick to its stated function. They do not expect their find-me-the-closest-bakery app to record their daily steps or monitor their caloric intake by photographing the cupcakes and cookies they buy. Similarly, asset managers who work hard to be able to say “there’s a fund for that!” should ensure that each fund sticks to its “that.”

Thank you for your indulgence on a topic that is important, but a lot to stomach over dinner. I am happy to speak with you about more scintillating topics during the Q&A.