Funds of funds
New voting rules are not investor-friendly

Shaken in their confidence to select funds and managers, investors have developed an appetite for bundled portfolio products - i.e. a funds-of-funds. Funds-of-funds (FoF) are old products that are making a big comeback. But new rules governing voting rights should cause some concern.

Old FoF rules

There are a number of rules pertaining to FoF products but our focus is on voting rights. National Instrument 81-102 previously prohibited mutual funds from investing in other funds. However, for the past twenty years or so, regulators have been allowing such structures, upon special application and with a number of special conditions. A "top fund" is the term given to the fund with holdings in other mutual funds. A bottom fund is one of the many mutual funds held by a top fund. For instance, CI Canadian Balanced Portfolio ("top fund") invests in a number of mutual funds, including CI Harbour fund ("bottom fund"). One of the conditions placed on the approval of FoF products related to voting.

Mutual fund investors have the right to vote on a number of fundamental issues, such as fund mergers, fee changes, mandate changes, etc. The old rule stated that, for instance, if CI Harbour fund wanted to change its fee structure, CI Canadian Balanced Portfolio would have taken all of the votes for units it holds, and passed them through to unitholders of CI Canadian Balanced Portfolio.

Regulators considered the manager of the top fund to be in a position of conflict when bottom funds held votes. This rule, however, has changed.

New rules

The new rule with respect to voting on issues of bottom funds is a little confusing and, frankly, less investor-friendly. The new rules allow the manager of the top fund to vote on issues pertaining to bottom funds. The only exception to this is when the manager of the top and bottom funds are affiliated, related, or the same.

In such instances, the new rule states that the manager of the top fund has two options: a) pass through votes to the unitholders of the top fund (as the old rule mandated) or b) to simply abstain from voting.

Implications

Managers of top funds voting on issues pertaining to bottom funds were, prior to the new rules, considered to be in a position of conflict. The proposed rule change implies they no longer feel that way. I maintain that the new rules expose managers to a greater level of potential conflict. Basically, fund managers must vote shares held in a mutual fund's portfolio in the best interests of unitholders of that fund.

Suppose that a fund proposes to introduce a higher management fee. All unitholders of the fund have a right (and are given the opportunity) to vote for or against the proposal. Suppose also that the fund is a holding in a related FoF product - i.e. a related top fund.

While the general rule dictates that managers must vote against the proposal, the manager is clearly in a position of conflict given the relation between top and bottom fund. Under the old rule, the manager of the top fund would have no choice but to pass through the votes to fund unitholders.

Under the new rule, however, the manager could simply abstain from voting and choose not to pass the votes through to unitholders. Abstaining from voting a significant number of shares will simply cause an important decision to be decided by a relative minority of unitholders. That's hardly a neutral impact.

The industry strongly supported this rule change given the cost of "passing through" votes and the relative passivity of fund unitholders. However, isn' t protecting our clients about further education and empowerment? As the saying goes, "if it ain't broke, don't fix it".