Weinbaum

A study by a finance expert at Cornell University's Johnson Graduate School of Management and three colleagues at other top business schools shows that mutual funds do better when the fund manager has "skin in the game" -- a financial investment in the fund's performance. Their findings, which were cited in The Wall Street Journal recently, could prompt the Securities and Exchange Commission (SEC) to revise proposed rulings.

"Overall, our results suggest that investors are indeed better off if the captains own the ship," says David Weinbaum, assistant professor of finance at Cornell's Johnson School.

The findings are important because, in the wake of accounting scandals, the SEC has proposed a requirement that all mutual fund boards appoint an independent chairperson and fill at least 75 percent of the board seats with independent directors, among its new rules to improve the governance of mutual funds and avoid conflict of interest.

The controversial SEC recommendation has been countered by the mutual fund industry's Investment Company Institute, which calls for fund directors to invest in the funds on whose boards they serve. And a mutual fund firm-commissioned report has found no evidence that funds chaired by a non-independent director perform worse or charge higher fees than those chaired by an independent director.

"Does Skin in the Game Matter? Director Incentives and Governance in the Mutual Fund Industry" is the title of the study by Weinbaum and co-authors Martijn Cremers, Yale School of Management; Joost Driessen, University of Amsterdam; and Pascal Maenhout, INSEAD. The findings, which are copyright protected, are accessible at http://www.johnson.cornell.edu/faculty/profiles/Weinbaum/.

To determine whether effective mutual fund governance is related to fund performance, the researchers used a unique database on the ownership stakes of independent and non-independent directors in the individual funds and families of funds they oversee.

Speculating on the study's results, they also examine whether directors' access to private information might lead them to pick investments that performed well in the past and avoid those that performed poorly -- but they find no evidence to support that. They also look at the previously documented relationship between governance structure and mutual fund fees but conclude that it only explains a small fraction of funds' results.

The researchers recommend that mutual fund investors take director ownership and compensation into account when making investment decisions, and they ask that such information be included in mutual fund prospectuses in a uniform format.

And they strongly make the point that all sides agree some form of governance of mutual funds is needed: "For all this disagreement [between the SEC and mutual fund firms], there is a consensus that conflicts of interest exist and that mutual fund governance practices are important and need to be improved," they write. How to do it in a way that ensures investors are protected and funds perform optimally is the challenge, says Weinbaum.