Morningstar.com, a sister site of Morningstar.co.uk, recently published a report on the governance of closed-end funds in the United States, commenting extensively on a revised paper from City of London Investment Group CEO Barry Olliff. Oliff's comments, and those of Morningstar CEF analyst Cara Essar, also ring true for corporate governance in the United Kingdom. The article is republished below.
Many citizens take the election of government officials quite seriously. These elected officials will go to Washington, D.C., or to our state capitals in an effort to represent us and our political beliefs. They are tasked with making hundreds, if not thousands, of decisions that will affect our everyday lives. In making these decisions, they are supposed to embody the interests of the citizens that elected them. At least, that's the ideal that our electoral system is based on.
This is also the ideal for the board of directors of a closed-end fund, or CEF, but shareholders take such elections far less seriously. Many investors (and citizens) don't even vote on the important issues affecting their fund. Those that do often simply rubber-stamp the status quo or the board's recommendations. If the board of directors is qualified, has performed the appropriate due diligence, and has demonstrated that it has shareholders' best interests in mind, voting with the board may be the right decision. But, I'd venture to guess that most shareholders don't even know the number of directors serving on a given board, much less whether or not the directors are qualified or have spent appropriate time analyzing the fund's important issues.
Corporate governance is an often overlooked aspect of investment analysis. Most investors find it a rather dry distraction from the far more interesting and dynamic discounts and premiums, distribution rates, and investment performance. But, the directors, if they truly take their fiduciary responsibilities seriously, should significantly influence these aspects. Ultimately, a fund's success or failure lays with its board of directors, and yet many investors couldn't care less about their ability to influence that board. For long-term shareholders--the owners of the fund--such negligence makes no sense.
Last week, Barry Olliff, chief executive officer and chief investment officer at City of London Investment Group, released a revised paper and hosted a webcast discussing his views on corporate governance. Barry has considerable credibility on this topic. Not only has he been investing in CEFs for about half a century, but his firm invests in funds and then attempts to persuade the funds' directors to implement more shareholder-friendly policies. The common term for such a firm is an "activist" investor, which carries a slightly derogatory tone in that it suggests that such firms are largely--and simply--agitators. Well, they are. They agitate the status quo, which we believe is the proper tactic in many cases.
During Olliff's webcast and in his paper--which is updated and published every year, he covered many topics. There is his argument for proper board structure (such as independence, how many boards are too many for a single director to serve on, and director pay). He discusses directors' communication (or lack thereof) with shareholders and also the board's relationship with the fund's manager.
We agree with many of Olliff's criticisms of boards of directors in the United States; we have often called out poor director behavior in our weekly articles as well as our CEF analyses. For many directors, the norm is often serving on hundreds of boards, with no specialised breakdown of functions, leaving--when one does the maths--about 15 minutes a year that could be properly devoted to any one fund. There is also the problem of funds (and directors) providing minimal information to investors and providing it in a less than timely manner. Olliff's comment that most funds seem to clear the absolute minimum hurdle to meet regulatory compliance--and do nothing more--rings true to us. That many directors adopt a do-nothing attitude regarding persistent discounts or premiums is just one quite troubling aspect of director inaction. The indifference to a fund having significant and ongoing tracking error to its underlying portfolio is astonishing, especially when investors now have a variety of alternatives that offer little tracking error in the form of exchange-traded funds, or ETFs. Olliff's criticisms are often sharp but he makes very strong arguments for changing the status quo of directorships.
One of the most interesting criticisms from Olliff is the board's definition of "long-term shareholder." Directors often refer to the elusive long-term shareholder as their primary fiduciary in decision-making. But "long-term" is not synonymous with "everlasting." Olliff argues that many shareholders can be long-term, even if they sell shares after a few years. Investors buy shares to meet investment objectives and may sell once those objectives are met. This does not make these shareholders short-term investors or traders. What's more, Olliff questions how directors can even claim to know which or how many investors are long-term when they don't even know their investors' average holding period. We think this is a great argument, but we would add that--in our opinion--directors need to act in the interests of all their investors, whatever the time horizon. A short-term investor who persuades directors to implement more shareholder-friendly policies is of great value to the fund's long-term shareholders. To us, this is a no-brainer.
This argument can be directly applied to persistent discounts and premiums at which some CEFs sell. Many boards proclaim that if they institute discount control mechanisms, they are supporting short-term shareholders and harming the interests of long-term shareholders. We find such arguments mind-boggling, as all shareholders would benefit from a lower tracking error. And yet, with regularity, directors issue press releases rehashing their status-quo proclamation that long-term investors don't care about discount-control mechanisms. They may as well state that their fund isn't interested in enabling its investors' asset-allocation and investment-objective needs. Let's face it: Allocation of capital to a CEF is an exhibition of faith that the CEF will perform alongside--if not outperform--the underlying asset class; given director insensitivity to tracking error (large premiums and discounts), such faith is often misguided, unfortunately and to say the least.
Shareholders also benefit from direct and frequent communication with the board of directors and managers. In our own experience, we have come across a number of fund families refusing to speak with us about their funds for fear of violating Regulation Fair Disclosure, or Reg FD. This regulation prohibits the disclosure of material nonpublic information to a party before it has been disclosed publicly and is often cited as a reason for directors and managers to avoid almost all communication with shareholders (and at times us). Olliff correctly asserts that Reg FD does not prohibit directors and managers from answering questions. We find a blanket rule of "no discussion with anyone" to be utterly ridiculous. In fact, such a rule suggests an incompetent compliance department that is unable to institute proper controls to ensure Reg FD observance, in our opinion. It also suggests a board of directors that is fearful of being held accountable to its investors. We are immediately sceptical of fund's practices when the fund hides behind Reg FD: the vast majority of funds speak to us, so what malfeasance is going on at fund's that prohibit executives, managers, and directors from speaking to us and investors? If the managers, board, and parent company are abiding by best practices, they should welcome a conversation.
Most fund companies regularly communicate with shareholders through press releases and annual reports. But, in addition to communication from the fund to shareholders, shareholders should have an avenue to ask questions of directors and managers. This is typically allowed at annual shareholder meetings, but many investors cannot travel to attend such meetings. Considering the availability of webcasts, video conferencing, and the like, CEFs should hold quarterly conference calls with managers and at least one representative from the board, allowing shareholders to ask questions. This is the normal way for companies with publicly traded equities to behave. Of course, we are not advocating for any violation of Regulation Fair Disclosure, but boards and managers should be more open to answering appropriate questions directly from shareholders. A transcript of the call could be promptly filed with the Securities and Exchange Commission to ensure no laws are broken. We won't hold our breath, though many funds do hold regular management calls, but without the chance for audience participation.
Finally, the relationship between a manager and the board of directors is especially important. If a manager is not performing up to par, the board should not hesitate to take action. In the real world, unfortunately, this is a very rare occurrence--at least in the U.S. A truly independent board with no ties to the manager or the fund company would be better equipped to make such a tough decision. Olliff believes that directors should lay out measurable criteria for manager evaluations and share these expectations with shareholders. He goes as far as stating that naming a fund after a manager can cause the board to lose sight of the fact that managers are under contract to run a portfolio. A contract can be terminated by either party at any time. Naming a fund after the manager implies--virtually guarantees--that the manager will not be removed even in the face of incompetent performance. In fact, it is far likelier that a fund will be liquidated than it is that the manager will be removed.
Olliff's paper is very detailed and includes a number of suggestions for improving corporate governance. Most of his ideas and arguments are in line with our own thinking. Boards have a responsibility to shareholders, and shareholders have a responsibility to be active investors. To get started--or for a refresher--I encourage everyone to take the time to read Olliff's paper and listen to his webcast. Ensuring that your directors are acting in your interests benefits all investors.
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