When mutual funds were required to set up independent review committees to resolve conflicts, investors were the intended beneficiaries. But after several years in operation, it’s hard to see if IRCs have, in fact, benefited investors.

The creation of mandatory IRCs had its roots in the fact that regulators had come to see the lack of fund governance as a real weakness of the Canadian mutual fund sector. Although the requirement for mutual funds to adopt IRCs was much more limited than the sort of governance envisioned in the original Stromberg report in 1995, the primary purpose was still to benefit investors.

A possible secondary benefit was that effective, independent oversight could allow regulators to loosen some of the restrictions that mutual funds faced. Yet, so far, it seems that while the benefit to the funds — in reduced restrictions — has materialized for some firms, it’s less clear if there has been any payoff for investors.

When the prospect of mandating fund governance first arose, the fund companies squawked that doing so would be costly and unnecessary. The regulators ultimately went ahead despite the industry’s objections, although the mutual funds were required to adopt IRCs with a much narrower mandate than initially envisioned. And, it turns out, many of the fund firms’ initial worries weren’t justified.

Indeed, earlier this year, the Ontario Securities Commission published the results of a review of the IRCs that examined, among other things, whether the fund companies’ fears — especially the cost, the difficulty of finding qualified people to staff the IRCs and whether IRCs may interfere with the management of funds — have been realized.

The OSC study found that the IRCs that were reviewed cost the funds only a tiny portion of their total assets under management. The review didn’t find any evidence that companies had any real trouble staffing their IRCs. Furthermore, the review found that the IRCs do not appear to interfere with the management of funds, thanks to the use of “standing instructions” — which fund managers can follow to deal with routine conflicts. (Many fund firms have a long list of standing instructions on issues ranging from proxy voting and personal trading to interfund trading and best execution.)

What the OSC review didn’t touch on was whether the IRCs are doing any good for inves-tors, despite the purpose of requiring independent oversight being to ensure that investors’ interests weren’t harmed by the conflicts that are inherent to many fund companies.

Yet, looking through a sample of IRC reports from a variety of firms over the past few years, it’s hard to find instances of an IRC actively intervening on behalf of investors. Most reports show the IRCs going along with whatever the fund managers are seeking to do. In the odd case in which breaches are revealed, they are sloughed off as immaterial, IRC policies are changed in response or the fund manager promises not to do it again.

To be sure, many of the potential conflicts the IRCs are being asked to weigh in on are either innocuous or are being resolved as fairly as possible. However, it’s not clear that there’s been much, if any, benefit to investors as a result.

“I’m not sure how effective IRCs have been,” says Dan Hallett, vice president and director, asset management, with Oakville, Ont.-based HighView Financial Group. “One of the problems is that the fund manager has to view an issue as presenting a conflict of interest to refer it to the IRC. Failing that, the IRC has no say.”

Hallett cites one case in which he believes a fund’s trade was clearly a conflict of interest but the fund manager disagreed: “[So] the IRC never knew about it.”

Also, from an investor’s point of view, it’s hard to evaluate the work of an IRC. Most of the IRC reports are full of boilerplate language and sparse disclosure. Such reports name the individual members of the IRC, but most don’t offer any biographical info or identifying details at all. For the average investor, it’s impossible to assess the independence or experience of most IRC members.

One notable exception to this is the report from the IRC for Quebec City-based IA Clarington Investments Inc. ’s funds, which provides markedly better information on both the members of the IRC and the terms of their compensation. Although all IRC reports reveal total compensation, the IA Clarington report also breaks down the components of the remuneration paid to each member.

In general, though, there seems to be little direct engagement between IRCs and fund unitholders. The members of the IRCs were appointed by the fund manager and have set their own compensation. Although the funds pay the IRCs rather than the fund manager paying them — in an effort to ensure the IRCs are working on behalf of unitholders — the reality is that investors have little say in who is supposed to be representing their interests, or what they do.

The one faction that does seem to have benefited from IRCs is the large fund companies, which have the most to gain from the loosening of restrictions on matters such as interfund trading and related-party transactions.

Steve Geist, president of CIBC Asset Management in Toronto, says that the introduction of IRCs has been very beneficial for his firm and, ultimately, for unitholders as well, as it has generated some efficiencies for both the firm and the funds.@page_break@IRCs have made it easier for CIBCAM to rationalize its fund lineup by facilitating proposed fund mergers, Geist notes. It also has become more cost-effective to do such things as changing auditors. For example, he says, before IRCs, a firm might find that it could cut its audit fees by switching auditors but the savings would be more than eaten up by the cost of holding a unitholder vote to approve the move.

There are other clear benefits to IRCs for large fund managers, particularly those that are bank-owned, as IRCs facilitate related-party transactions — trading in the securities of the parent bank, for example, or participating in underwritings that involve the bank-owned dealer.

But, Geist says, the ability to trade between funds with IRC approval has probably been the biggest advantage. He says this has been hugely beneficial for CIBCAM, particularly for its large portfolio programs, for which a fund manager who wants to alter asset allocation may have a very large position to move. Making that sort of trade in the market carries significant costs, and executing it internally can be more economical.

“Not having to go to market with hundreds of millions of dollars of bonds, when you can just buy them back with another portfolio — that saves a great deal of money,” Geist says, adding that reducing those costs and rebalancing more efficiently ultimately improves returns for unitholders.

Although certain firms might be seeing bottom-line benefits from IRCs, there’s not much evidence that investors overall are paying lower costs and/or getting better investment performance since IRCs were introduced. Investment Executive examined a sample of more than 400 mutual funds, comparing their reported management expense ratios from 2007 (when mandatory fund governance was implemented) with their MERs at the end of 2010. The data show that MERs have barely moved. On average, MERs have dropped by seven basis points since IRCs were adopted; the median drop is just two bps.

Most of the biggest MER reductions in that period were for money market funds. Excluding those funds, the average drop in MER was less than three bps — and the median drop was just one bps. These tiny changes indicate that fund governance isn’t having any meaningful impact on unitholders’ costs; or, if it is, it’s being offset by rises in other components of the MER.

As for investment performance, it’s hard to see much evidence of improvement there, either. There’s no sign that more fund managers are outperforming their benchmarks since IRCs were introduced. Indeed, the latest report from Russell Investments Canada Ltd. indicates that just 39% of Canadian large-cap fund managers beat the S&P/TSX composite index in the first quarter of 2011 — and the median return for large-cap fund managers lagged the index in the same quarter.

Yet, there is some academic evidence that sound governance can positively influence returns. For example, a recent paper from Morningstar Inc. evaluated the relationship between fund performance and the “stewardship” grades Morningstar bestows on funds in the U.S. The study found that funds that receive poor grades for stewardship are more likely to be eliminated (liquidated or merged into another fund). And funds with average or better grades were not only more likely to survive, they also were more likely to deliver good performance — defined as ranking three stars or higher by Morningstar, which indicates a fund is generating relatively good returns on a risk-adjusted basis.

Morningstar recently introduced these stewardship grades in Canada — albeit at the fund-company level rather than the fund level (as they are used in the U.S.). And although there may prove to be a positive correlation between Morningstar’s stewardship grades and investment performance in Canada as well, the sort of governance qualities those stewardship grades capture — which seem to filter through to the bottom line — go far beyond the relatively limited mandate of Canadian IRCs.

The stewardship grades that Morningstar awards evaluate overall corporate culture, manager incentives, fees and regulatory history in an effort to rate the extent to which a fund company’s interests are aligned with its unitholders’ interests. This is a much more expansive definition of governance than what is covered by the work of an IRC, which doesn’t have a broad say in whether investors are being treated fairly or not by the fund company.

However, there’s some sense that the introduction of some minimum level of mandatory governance is a good thing, even if the benefits aren’t obvious or measurable. Tom Bradley, president and co-founder of Vancouver-based Steadyhand Investment Funds Inc. , suggests that although IRCs may not be doing much to block the large fund firms from specific trades, he has no doubt that they have “made the banks and insurers more careful about how they throw their weight around.

“These firms don’t hesitate to use their scale and breadth to their advantage and, sometimes, the Chinese walls are pretty thin,” he continues. “I just wish the investment banking and institutional equity departments had the equivalent of an IRC — now, that would be interesting.” IE