What's different about being a trustee of a bank-affiliated mutual fund?
That's the question that Richard J. Herring, an independent director of the BT Funds, set out to answer last week. He was one of 60 people who spoke at the Securities and Exchange Commission's two-day roundtable on the role of independent investment company directors.
Mr. Herring, a professor of international banking at the Wharton School of the University of Pennsylvania, cited several factors that set bank- affiliated funds-and by extension, their trustees-apart from the rest of the fund industry. Among them:
Bank funds are overseen by multiple regulators-three in the case of Bankers Trust Corp.'s $27.7 billion-asset fund family.
Bank investment advisers are exempt from SEC registration.
Conflicts can crop up between bank and securities regulators, which have different priorities and missions.
Banking companies face questions about their commitment to the fund business, which is usually a small part of their entire business.
He also saw differences in the regulatory constraints banks face and in the attention banks pay to risk management-points that are elaborated on in the excerpts that follow.
Administrative rulings have eased the constraints imposed by the Glass- Steagall Act on most other bank activities, but the act still constrains the way in which mutual fund activities can be structured.
Officers of the bank may not serve on the mutual fund board of trustees. The BT Fund boards are comprised exclusively of outside trustees. Although the board meets in executive session with the fund counsel at each quarterly meeting, the relevant bank officers are present during the rest of each meeting. Although I would not be troubled by the presence of a bank officer on our board, the present arrangement may have the effect of giving a greater sense of independence and responsibility to outside trustees with little apparent loss of efficiency.
Bank-affiliated funds are obliged to employ an unaffiliated distributor for retail distribution of fund shares. The BT Funds have employed several different distributors over time-Drexel Burnham, Kemper, Signature, Federated, and now ICC.
This constraint on bank underwriting powers appears anomalous in an era in which banks can underwrite issues of equity and high-yield debt for their corporate customers.
This additional complexity in mutual fund operations is a distraction for the trustees that does not appear to add value for our shareholders.
The Glass-Steagall Act impedes new product development by making it more difficult to obtain seed capital for new funds. But even if the Glass- Steagall Act were lifted, a bank's ability to seed new funds would still be severely constrained by the Bank Holding Company Act, which prohibits the bank holding company, its affiliates, or the 401(k) plans of its employees from holding more than 5% of the shares of a mutual fund.
To Risk Management
A large, sophisticated international bank employs a wide array of risk management tools to manage its own risk exposures. Many of these tools may also be used to evaluate the risk exposures of mutual funds. At the BT Funds, members of the asset management group have worked with the trustees to develop several procedures for monitoring the risks of our funds.
Banks have long and deep experience in evaluating credit risk. The BT Funds board has derived comfort from the credit risk analysis resources of the bank in connection with monitoring the credit risk of all fixed-income securities, counterparties to repos and swaps, and guarantors. This has been especially helpful in the development of the new Preservation Plus Fund.
Several of our funds hold securities that trade in markets that are markedly less broad, deep, and resilient than the government securities market. In cooperation with the board, the fund management unit has developed a methodology for conducting liquidity studies.
These studies examine the fund holdings relative to normal daily volume in the markets in which the asset is traded and compare our mark-to-market prices with actual transaction prices. The board examines a liquidity study of at least one fund each quarter.
Bankers Trust has developed a risk management system to manage its own business that is known by the acronym RAROC, the risk-adjusted return on capital. In response to the SEC's request for proposals for a more meaningful way to disclose mutual fund risk to shareholders, Bankers Trust submitted a proposal to apply RAROC to mutual funds.
Although the SEC has opted for a much simpler kind of disclosure, Bankers Trust uses the RAROC methodology to monitor the performance of investment managers and presents these reports to the board. These reports help the board monitor fund performance on a risk-adjusted basis and understand the difference between the investment choices our fund managers have made and the appropriate benchmark.