A Better Grasp of Non-financial Risks

The European Fund Management Industry Needs a Better Grasp of Non-financial Risks — December 2010

3. Risks and Responsibilities in the Fund Industry

(the shareholder is called the principal); the separation of ownership and control means that shareholders lose control over managerial decisions. In investment funds, the separation of ownership and control is extreme; unit-holders participate almost not at all in supervision (except in dedicated funds). Morley, Curtis, and Olin (2010) note that mutual funds differ from ordinary companies most greatly in the right to exit. In ordinary companies, individual shareholders can exit, but assets cannot. When a shareholder sells, the assets that underlie the shares remain part of the company. In a mutual fund, by contrast, shareholders do not sell their shares—they redeem them from the issuing funds for cash. When a shareholder redeems, the fund pays the underlying assets to the shareholder, the fund shrinks accordingly, and the shares are extinguished. The right to redeem assets makes mutual funds more like products or services than like ordinary companies, and it profoundly influences voice, that is, unit-holders’ interest in participating in fund management decisions and in acting to supervise them: “Imagine two mutual funds with identical assets and net asset values (NAVs) but different fees, and managers of differing quality. The two funds will have the same share prices but different expected returns. Investors in the fund with the lower expected returns could theoretically improve the fund’s returns by voting and fee liability. But they won’t bother, because they’ll prefer instead to redeem their shares in the low-return fund and switch to the high-return fund. Since the two funds have the same share price , it costs no more to invest in the high-return fund than in the low-return fund. And since mutual fund share prices do not reflect expected returns, activism that improves a fund’s returns in the future will not affect the share price at which an activist investor can sell in the present . Shareholders of ordinary companies cannot switch so easily, because ordinary company stock prices impound information about future cash flows. Imagine two companies with identical assets, but managers of differing quality. The two companies will have different expected cash flows and therefore different share prices as well. Switching from the poorly managed company to the well managed company will require selling the shares of the poorly managed company at a low price and buying the shares of the well managed company at a higher price. The difference in share price makes switching costly. Additionally, activism that improves a company’s performance in the future raises the stock price in the present . Sometimes, therefore, it makes more sense for an ordinary company’s shareholders to use voting and boards to improve the company’s performance and raise the share price than to sell at the current price” (Morley, Curtis, and Olin 2010, 4). Because the current valuation of the fund is not influenced by actions from unit- holders, exiting will be the preferred strategy when there is little friction, that is, when redeeming units and buying new ones is not costly.

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An EDHEC-Risk Institute Publication