Inside the July 2012 Issue

• Why Mutual Fund Guardians Are Failing
• Pack Mentality: Traveling With Pets
• A Look Inside Professional Day Trading
• 10 Things Divorce Attorneys Won't Say

When Charles Schwab's popular YieldPlus bond fund started to tank during the financial meltdown, the fund's problems went beyond the queasy markets. YieldPlus, according to the fund's prospectus, was designed to offer "high current income with minimal changes in share price." That didn't turn out to be the case in 2008, when the fund's net asset value plummeted more than 35 percent, some four and a half times what short-term bond funds lost as a whole. Nor was it true in 2009, when shares of the once-stable fund tumbled another 11 percent.

Apart from the obvious financial turmoil of the times, however, there were an array of hidden reasons for the fund's sudden fall. In public disclosures, YieldPlus's managers had said the weighted average maturity of the bonds the fund held was six months, a mark of safety; the Securities and Exchange Commission later said the average reached as high as 2.2 years. As a result, when the broader market imploded, the fund was forced to unload its holdings at fire-sale prices, leading to deeper losses. YieldPlus's registration statement said the managers would not place more than 25 percent of assets in certain types of securities, at least not without explicit shareholder approval. But not long before the market went into free fall, managers stuffed about 50 percent of its portfolio with nongovernment mortgage bonds, the SEC said in a January 2011 cease-and-desist order. And during the crisis, when investors and brokers asked if redemptions were draining the fund, Schwab's lead portfolio manager said in a conference call, "We've got very, very, very slight negative flows," according to the SEC. In fact, the fund had hemorrhaged more than $1 billion in the preceding two weeks.

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"Even the most independent and conscientious board members have no real leverage in negotiating with managers over fees," says John Morley, a University of Virginia Law School professor.

In the end, Schwab, without admitting or denying wrongdoing, would agree to pay $119 million to settle SEC civil charges that it misled investors; the company also paid $235 million to settle a private case brought by investors. Schwab, saying it was constrained by the settlement terms, declined to comment on the matter. Last year, though, it attributed the fund's losses to an "unforeseeable credit crisis" and said it "would never seek to profit at the expense of its clients."

But while the YieldPlus incident may have directly affected the shareholders of just one Schwab fund, it shines a rare spotlight on something that could well affect any investor in the roughly 7,700 portfolios in the $12 trillion mutual fund industry -- where a quarter of American household assets are now kept. In the case of YieldPlus, say some critics, an important if little-known layer of investor protection failed. This safeguard did not involve a government agency or an outside auditor, but an internal group of highly paid overseers: the fund's own board of trustees. The lapses in oversight that occurred with YieldPlus, experts say, are part of a system of fund governance that is almost designed to fail. "The real puzzle isn't why these safeguards don't work," says John Morley, a University of Virginia Law School professor who has studied the issue extensively. "It's why anybody thinks they could work."

Circle of Trust? Infographics by Emily Cooper for SmartMoney

Investor advocates say governance at America's mutual funds could be a lot more rigorous. Here are seven boardroom concerns critics say should be on the table.

Though it may come as a surprise to most investors, every mutual fund has a built-in mechanism to try to shield investors from management disasters: a board of directors or trustees whose primary job is to act as a watchdog for shareholders. Created by the Investment Company Act of 1940, the boards have a clear mandate to monitor potential conflicts of interest, review and approve key fund documents such as prospectuses, and ensure that advisers provide satisfactory investment returns with reasonable fees. In theory, fund directors fulfill the same general role as the directors of public companies, with broad powers to safeguard shareholder interests -- including, if necessary, firing the advisory firm running the fund. "Without boards, you would have rogues who would take advantage of the public," says Dorothy Berry, president of Talon Industries in New York, who has served as a mutual fund trustee for the $8.7 billion PNC fund family and who chairs an industry trade group, the Independent Directors Council.

But a five-month investigation by SmartMoney shows that this layer of protection may be among investors' most porous. Unlike their cousins in corporate America, mutual fund boards typically don't hold annual shareholder meetings or shareholder votes. It is almost unheard-of for a fund's investors -- its owners -- to remove a director or change the management fee. Even the notion that the boards have an "arm's-length bargaining" relationship with the advisory companies they hire and oversee is something of a legal fiction. No less an authority than the U.S. Supreme Court has noted, in a 2010 ruling, that a mutual fund often "cannot, as a practical matter, sever its relationship with the adviser." Indeed, that inseparable relationship begins on day one: When an advisory firm opens up a new small-cap stock fund or long-term bond portfolio, for example, it handpicks that fund's directors -- who, in theory, can vote themselves onto the board for life. (Fifteen percent of mutual fund directors stay for 20 years or more, while only 6 percent of corporate directors stay that long, according to research firm GMI Ratings.)

Still, while shareholder activists and regulators have brought corporate boards to heel in recent years, advocates say there's nothing in place to prevent another YieldPlus debacle from happening in the fund industry. Last decade's lapses of corporate governance have since become the stuff of business-school case studies, but mutual fund boards have received scant attention, even though the stakes for the public are tremendous. About half of America's retirement savings -- including IRAs and money held in defined-contribution plans like 401(k)s -- is invested in funds. Participants in many company 401(k) plans, moreover, have only a handful of funds to choose from.

The lack of attention frustrates investor advocates like Niels Holch, a Washington, D.C., lawyer who started the Coalition of Mutual Fund Investors in 2003 to agitate for reform in the wake of past fund scandals. He says he has had little luck mobilizing investors, despite the fact that many of the board members' salaries, which are determined by the directors themselves and taken out of shareholder assets, are so eye-catching. Indeed, directors, who typically attend between four and eight multiday board meetings a year, are paid an average of roughly $260,000 annually at the largest mutual fund families, according to a SmartMoney analysis. One longtime fund director, at a smaller fund family, pulls in more than $1 million a year overseeing some 170 mutual funds. Having watchdogs so cozily ensconced "diminishes their ability to stand up to managers," says former SEC chairman Arthur Levitt, echoing the view of many experts interviewed for this story. "Being on a mutual fund board," he says, "is the most comfortable position in corporate America."

In the case of Schwab's YieldPlus, many of the management mishaps were "classic examples of things where boards are supposed to have responsibility," says Alan Palmiter, a professor at Wake Forest University School of Law and an expert on mutual funds. According to the SEC's order, the YieldPlus board let managers break the fund's 25 percent limit on holdings of certain risky mortgage bonds, approving this critical change without putting it to the required shareholder vote. The judge overseeing the private lawsuit against Schwab called the board's decision to remove the concentration limit "an entire repudiation of a clear-cut definition that had become a fixture of the fund." (A Schwab spokesperson says its fund trustees "are wholly committed to acting in the best interest of shareholders.")

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Donald Stephens, managing director of investment firm D.R. Stephens & Co., a YieldPlus director at that time, says he does not recall if the issue of putting the rule change to a shareholder vote came up. Still, he says, "in the 20-plus years I was there, the board was very diligent, and the adviser kept us amazingly well-informed." Before each meeting, Stephens says, he and his fellow directors received board books that were 8 or 9 inches thick. But Stephens, who chaired the board's marketing committee, acknowledges that the directors never asked about the fund's marketing materials that seemed to offer investors a risk-free fund; that, he says, was beyond the scope of the board's work. "We weren't really there for the marketing," he says. "Our job wasn't to tell them how to run their business."

Even critics say the makeup of fund boards has improved over the years. Not so long ago, say industry insiders, boards were stuffed with golfing buddies of executives at the advisory firm. "I used to see dentists or the owner of a local car dealer," says Paul Dykstra, a Chicago-based partner at K&L Gates who advises mutual funds and boards. But today, he says, empty slots for "independent" directors are often filled from the usual spots: business-school faculty, Wall Street, the Harvard Club. (Boards typically also have a small number of "interested" directors, who are affiliated with the adviser.) According to a SmartMoney analysis of 217 independent directors at the 25 largest fund families, by actively managed assets, more than a third are current or former company CEOs, at least 62 have MBAs, and 43 are professors -- current or emeritus. One is a cardiologist.

The Directors

Illustrations by Emily Cooper for SmartMoney

SmartMoney pored through the regulatory filings of the 25 largest mutual fund families to paint a portrait-by-numbers of their directors. A look at who's protecting your money, how many portfolios are under their watch -- and how much they get paid for the effort.

Nonetheless, an occasional celebrity figure or sports legend ends up in this inner circle -- names such as Stefanie Powers, the actress, or Gale Sayers, the onetime Chicago Bears running back and Pro Football Hall of Famer who built his own $85 million technology business. Powers, who serves on an American Funds board that oversees the $72 billion Capital World Growth and Income fund as well as two other portfolios, starred five seasons in the 1980s television series "Hart to Hart." "She certainly brings a perspective to it that others do not," says Paul Haaga, chairman of Capital Research and Management, the advisory company that manages the giant American Funds family. (Powers and Sayers declined to comment for this article.)

But while individual qualifications are rarely an issue, investor advocates say mutual funds allow far too many directors to serve on multiple boards. In the realm of public companies, people can draw criticism for sitting on more than a handful of boards. But YieldPlus's trustees, in 2010, each served on the boards of 72 other Schwab funds -- each with its own lengthy prospectus, regulatory filings and compliance issues to review. And that, it turns out, is nothing compared with Bruce Crockett's responsibilities on behalf of investors in the Invesco family of funds. Crockett, a former CEO of satellite company Comsat, is a shareholder watchdog for 140 stock and bond funds, roles for which he was paid $693,500 in 2011. For many critics, vetting so many funds is hard to fathom and is a prescription for overwhelmed and passive boards. "Maybe we're just not as smart as they are," says Steven Melnyk, a former ABC golf commentator-turned-investment banker, who says he has his hands full serving on three fund boards at Longleaf Partners. "But I can't imagine how, if you're at a large fund complex, you could find the time to really review everything you need to look at." The required reading alone, says John Bogle, founder of fund giant Vanguard, underscores the challenge. "Mutual fund directors," he says, "are either not being paid nearly enough for what they should be doing -- or far too much for what they actually do."

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Close Photograph by Matthew Mahon for SmartMoney

"Performance? That part's my job, not the board's job," says Donald Yacktman. "I've never changed my fees because of pressure from the board."

In an interview, Crockett, who has served as a fund trustee for 34 years, says directors can handle multiple board duties because many of the issues are similar and because directors become quick studies. "The more funds the board oversees, the more economies of scale you enjoy," he says. And to ease the workload a little, some boards will assign oversight of certain funds to certain directors. While Crockett and more than 20 other board members interviewed by SmartMoney acknowledge that they rarely duke it out at meetings, they say it is only because they and the advisers tend to see things in a common light: "Our interests are aligned," says Crockett, who also sits on the board of the Investment Company Institute, the trade group representing the advisory firms.

Likewise, executives at advisory firms say the suggestion of board rubber-stamping is off the mark. "I'm not stupid," says Capital Research and Management chairman Haaga. "I don't make proposals that will be rejected by the board." Still, investor advocates say there's a thin line between getting along and going along. In the world of corporate governance, by comparison, some boards have openly clashed with executives, with directors at roughly a dozen major companies replacing CEOs in 2011. But fund insiders say they can't recall more than a handful of cases of advisers being replaced; it's rare for a board to even push for the firing of a portfolio manager. In response, directors say that kind of pressure isn't needed, because advisers know when one of their own isn't performing well. "I don't have to tell them to fire Joe Jones or somebody," says Crockett. "It's not our job."

But few investors know what the duties of fund directors are, in part because funds don't hold shareholder meetings. Nor would most outsiders have an easy time finding out how much trustees get paid or how many boards they sit on -- such details are tucked in an obscure document called the "Statement of Additional Information." Among the surprises: A former top executive of The Dreyfus Corp. is the "independent" chairman of the board for 173 funds in the Dreyfus family. Joseph DiMartino, who was the company's president until retiring in 1994, was given the role of board chairman a year later and now receives a $1 million-plus pay package from Dreyfus fund investors. A spokesperson for Dreyfus says it "does not elect fund board members or determine or approve board member compensation." DiMartino declined to comment, but one fellow trustee, W. Hodding Carter III, a former State Department official, says DiMartino uses his experience to extract good deals on fees for shareholders. "Do I have any quibbles over paying him $1 million?" asks Carter. "No, he works his ass off."

At the J.P. Morgan fund complex, Fergus Reid III, the 79-year-old chairman of a plastic-injection-molding company, serves as chairman of all 154 family funds -- while also sitting on the boards of 105 funds run by one of the firm's longtime rivals, Morgan Stanley Investment Management. In an interview, Reid, who earned nearly $660,000 in 2011 for the multiple board roles, says his "personal firewall is just as honorable" as that of any big auditor or law firm that represents competing businesses in the same industry. Still, he says, the fact that no one has ever challenged him on the issue "does surprise me a little." (J.P. Morgan Asset Management says it is confident in the commitment of board members; Morgan Stanley declined to comment.)

Fund meltdowns, such as the one at YieldPlus, are rare. But critics say millions of Americans have already experienced the cost of the mutual fund governance problem -- and that it is far from small. The impact, they say, begins with the industry's own performance and ends with the high management fees that eat even further into those returns. In 2011, only 23 percent of actively managed equity funds beat their benchmarks (and only 20 percent beat Standard & Poor's 500-stock index). It was, according to Morningstar, the worst showing for active fund managers in more than a decade. Over the past five years, 61 percent of stock funds have lagged the S&P 500.

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Close Photograph by Matthew Mahon for SmartMoney

"In my view, a board can't do 100 funds," says Dick Zucker, a former fighter pilot and now chairman of the board that oversees the 46 USAA funds.

That weak performance, most studies say, is partly due to fees and other expenses. On an asset-weighted basis, the average actively managed stock fund charges shareholders annual expenses of 0.9 percent, or $90 for every $10,000 invested, according to Morningstar. Even the most successful managers find that headwind difficult to offset over time. (Index funds consistently outperform their managed counterparts after expenses, which average an asset-weighted $16 per $10,000 invested.) And, of course, some funds also assess sales loads of 5 percent or more. Such fees "make a huge difference" in the bottom line but rarely get attention, says Annette Nazareth, a former SEC commissioner.

John Hill, a director of Putnam Investments' funds, says the fees his board negotiates are "a great deal for investors," particularly compared with European funds, though he concedes that may not be so obvious to shareholders, who don't get to see the financial data the board sees. By their own admission, however, many fund board members say they are loath to quibble with advisory firms over fees. If they wield too heavy a hand -- or force fees too low -- they'll risk losing the most talented portfolio managers to higher-paying hedge fund jobs. But critics long familiar with the fund industry -- including former SEC chairman Levitt and Harvard's John Coates -- say fund directors simply don't have the incentive to push back on fees. "Absolutely, the board does not negotiate the lowest price," contends Coates, the author of several influential studies on mutual funds. "There is really a kind of bargain" that this "quasi-regulatory body" offers, he says. "They shelter the advisers from lawsuits; in return, they provide a weak check on advisers."

Ultimately, though not great for investors, such fees remain the bread and butter of advisory firms, fattening up profit margins to a level that would be the envy of most major public corporations. Indeed, fund research firm Strategic Insight has calculated average pretax operating margins for publicly owned advisory companies at almost 40 percent, nearly three times the average for S&P 500 companies; one company, Capital Research and Management, had profit margins of about 50 percent in several years prior to 2007. "I think investors would be shocked if they really saw how profitable funds can be," says Paul Ellenbogen, a consultant to fund boards for Morningstar.

For now, few advocates anticipate that legislators will take up any new reform initiatives on mutual funds. Indeed, when Congress drafted the sweeping changes of the Dodd-Frank Act, an effort intended to curtail some of the more egregious practices that led to the recent financial crisis, the fund industry was left virtually untouched. According to Barry Barbash, an attorney who once ran the SEC's division of investment management and who now represents fund boards, mutual funds didn't sell the subprime mortgage securities or credit-default swaps that became such a lightning rod for change. "They were perceived to be more victims of the financial crisis," he says.

If change is going to come, most observers say, the fund industry itself will probably have to make it happen, if only to respond to growing criticism about mutual fund performance in general. Quietly, a handful of firms have taken some steps. Among the biggest is the one from Fidelity, which in 2008 split in two the board that had overseen 376 funds; the fund giant cited as a reason growth in its business and "the increasing complexity of the securities marketplace." Likewise, Dick Zucker, vice president of a San Antonio roofing company and chairman of the USAA fund board, says he and his fellow directors have already discussed splitting the board in two, should the firm grow much bigger than it is. USAA has just 46 funds now.

Some years back, one adviser offered a more forceful critique of the fund-oversight system: He persuaded his investors to sack his whole board. In the 1990s, Donald Yacktman, the blunt, charismatic Midwesterner who runs Yacktman Asset Management, grew so frustrated with his fund's then-directors that he organized a rare shareholder vote to have them replaced. Indeed, while Yacktman, 70, offers effusive praise for his current directors, he's still dismissive of fund boards in general. "Much of what they do is protect the SEC from blame if there's ever a problem," he says. "It's like an extra X-ray that a doctor does to avoid lawsuits."

Dan Calabria, a former executive at the Oppenheimer and Templeton funds, agrees -- at least about one thing: The boards, he says, do little to help investors as they stand now. But Calabria, who served on several fund boards before retiring in 2007, insists it doesn't have to remain that way. He contends that these watchdogs already have the statutory power they need to get the best deals for shareholders -- but that investors must first get organized and demand they use it. "We need to form a labor union of mutual fund shareholders," says Calabria. Short of that, there's no chance the system will change, he says. "No way."

Additional reporting by Linda Lacina .