Shareholder rights

Like common stockholders, mutual fund shareholders are granted certain rights. We’ll cover the following in this chapter:

• Right to vote for the Board of Directors
• Right to vote on fund-specific matters
• Right to pro-rata share of dividend and capital gain distributions
• Right to fund disclosures

Right to vote for the Board of Directors

Mutual fund shareholders maintain the right to vote for the Board of Directors (BOD) (sometimes called the Board of Trustees). The BOD is a group of shareholder-approved board members with industry knowledge or valuable insight whose primary role is representing shareholder interests. They oversee the overall operation of the fund and ensure its compliance with relevant securities regulations. If something goes wrong (e.g., the fund is not complying with the law, the portfolio is not aligned with the fund’s objectives, etc.), it’s the BOD’s responsibility to fix the problem.

Additionally, the BOD is responsible for nominating and overseeing the fund’s investment adviser (the company responsible for investing the fund’s assets). The investment adviser employs the fund manager, the person responsible for investing the fund’s assets. These are important roles as they control shareholder money. Once the investment adviser is appointed, shareholders must approve* their initial contract, which can last no more than two years. The contract is subject to annual renewal from there, although only one of the BOD or a majority of shareholder votes must approve (not both). If the fund performs poorly, the BOD can replace the investment adviser and fund manager.

*Approval requires a majority of shareholder votes. Like common stockholders, shareholders are granted more voting power with each share owned. In particular, a shareholder gains one vote for each dollar invested in the fund. A majority of shareholder votes does not necessarily mean a majority of shareholders. For example, let’s assume one shareholder maintains a position worth 51% of the entire fund while a million other shareholders own the remaining 49%. If the one shareholder holding the 51% position votes to approve an item and the other million shareholders vote against it, the one shareholder’s vote wins. It’s about voting power, not the number of shareholders voting!

The Investment Company Act of 1940 requires at least 40% of the BOD to be independent to ensure the BOD is as unbiased as possible. To be considered independent, also known as “non-interested,” a board member must not have any related business with the fund sponsor, investment adviser, or fund affiliates within the past two years. On the other hand, interested (non-independent) board members usually do business with or are employees of the sponsor, investment adviser, or fund affiliates (e.g., a subsidiary of the fund sponsor). While any board member should “speak up” if something fund-related needs fixing, independent members are likelier to do so given their lack of attachment.

Right to vote on fund-specific matters

Shareholders are typically asked to vote on a variety of fund-specific matters annually. Similar to common stockholders, shareholders can vote on important issues related to the investment. For mutual funds, this includes:

• Changes to the fund’s objective
  • For example, changing a stock fund to a bond fund
• Changes to the fund’s structure
  • For example, changing from an open-end to closed-end fund
• Changes to the fund’s fee schedule
  • For example, implementing 12b-1 fees*
• Changes to the fund’s diversified status
  • For example, reclassifying a non-diversified fund as diversified

*12b-1 fees are marketing fees, which we will discuss later in this unit.

Right to pro-rata share of dividend and capital gain distributions

Most mutual funds make distributions annually to shareholders. Dividends represent income received from investments within the fund’s portfolio. For example, the Schwab Dividend Equity Fund (ticker: SWDSX) primarily invests in dividend-paying stocks and makes quarterly dividend distributions to shareholders. In 2022, the fund made dividend distributions equaling roughly $0.30 per share.

The fund also made a capital gain distribution of roughly $0.62 per share. This type of distribution occurs when the fund manager sells a security in its portfolio at a gain, then distributes the profit to shareholders. For example, assume the Schwab fund establishes a $10 million position on Coca-Cola Co. stock (ticker: KO), then sells the position for a total of $15 million a few years later. The fund could then distribute the $5 million gain to shareholders. These distributions are made once per year, typically in December.

Shareholders maintain the right to receive dividend and capital gain distributions, but do not have the power to vote for them. Instead, the BOD approves dividend payments. It’s common for the BOD to approve these distributions as there are tax incentives to do so (covered later in this unit).

Right to fund disclosures

Most securities issuers are required to make in-depth and lengthy disclosures to investors. Mutual funds are no exception; in fact, mutual funds involve numerous disclosures, including:

• Prospectus
• Statement of additional information (SAI)
• Annual SEC report
• Semi-annual shareholder report

Prospectus

The prospectus, sometimes called a statutory prospectus, discloses all important fund-related information to potential investors and current shareholders. It must be delivered to investors at or prior to a solicitation (recommendation), or by the settlement of a fund purchase if unsolicited (no recommendation from a financial professional). In today’s digital world, most investors are provided electronic access to their prospectus (by link when buying shares online or via email).

Information disclosed in the prospectus includes:

• The investment objective
• Shareholder fees
• Past performance (at least 1, 5, and 10-year returns)*
• Details on investment adviser and fund manager
• Related risks
• Fund policies**
• Financial highlights***

*Funds that have existed for at least 10 years must disclose the past 1, 5, and 10-year returns. If a fund is not at least 10 years old, it must disclose as much of the typical requirements, plus the life of the fund. For example, a fund in existence for 7 years would disclose the past 1, 5, and 7-year returns. Or, a fund in existence for 4 years would disclose the past 1 and 4-year returns.

**Fund policies include minimum required investment (e.g., minimum $2,500 required to invest), availability of shares (e.g., shares only available to US citizens), and excessive trading policies (restrictions imposed on investors that quickly liquidate shares).

***Financial highlights include the fund’s historical income and expenses.

A fund prospectus can be dozens of pages long and difficult to read from beginning to end. A summary prospectus, a condensed form of the prospectus, may be delivered instead of the statutory prospectus.

To view a real world version of these documents, click these links:

• Fidelity Value Fund statutory prospectus
• Fidelity Value Fund summary prospectus

Statement of additional information (SAI)

The statement of additional information (SAI) discloses the detailed “in the weeds” information related to the fund. Most shareholders never read the SAI, but it is the perfect document for an investor seeking knowledge on every aspect of a fund’s operations. Information in the SAI includes micro-details on:

• Fund policies
• Investment-making decisions
• Fund’s financials
• Board member backgrounds

The SAI is not required to be delivered to investors, but must be made available upon request.

Click this link to view the SAI for the Fidelity Value Fund, a real world version of this disclosure.

Annual SEC report

Funds must file annual Securities and Exchange Commission (SEC) reports, which are made publicly available by the SEC upon receipt. These reports include:

• Market recaps over the previous year
• Fund manager comments
• Investment summary (details on fund portfolio)
• Financial statements (balance sheet, income statement)
• Financial highlights (income, expenses, returns)

Click this link to view the SEC annual report for the Fidelity Value Fund, a real world version of this disclosure.

Semi-annual shareholder report

Funds must make semi-annual reports available to their shareholders. Most of the information disclosed overlaps with the disclosures made in the annual SEC report, including:

• Investment summary (details on fund portfolio)
• Financial statements (balance sheet, income statement)
• Financial highlights (income, expenses, returns)

Click this link to view the semi-annual shareholder report for the Fidelity Value Fund, a real world version of this disclosure.