Financial Markets and Institutions (2-downloads)

10. Why have banks been losing cost advantages in

acquiring funds in recent years?

11. “If inflation had not risen in the 1960s and 1970s,

the banking industry might be healthier today.” Is

this statement true, false, or uncertain? Explain

your answer.

12. Why have banks been losing income advantages on

their assets in recent years?

13. “The invention of the computer is the major factor

behind the decline of the banking industry.” Is this

statement true, false, or uncertain? Explain your

answer.

14. How did competitive forces lead to the repeal of the

Glass-Steagall Act’s separation of the banking and the

securities industries?

15. What will be the likely effect of the Gramm-Leach-

Bliley Act on financial consolidation?

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The Mutual Fund Industry

Preview

Suppose that you decide that you want to begin investing for retirement. You

would probably want to hold some money in a diversified portfolio of stocks.

You might want to put some money in bonds. You might even want to hold

stock in some foreign companies. Now suppose your budget will only let you

invest $25 per week. How are you going to build this retirement fund? You will

probably not want to buy individual stocks, and with only $25 to spend at a

time, you will not be able to buy bonds. The solution to your problem is to

invest in mutual funds.

Mutual funds pool the resources of many small investors by selling them

shares in the fund and using the proceeds to buy securities. Through the asset

transformation process of issuing shares in small denominations and buying

large blocks of securities, mutual funds can take advantage of volume dis-

counts on brokerage commissions and can purchase diversified portfolios of

securities. Mutual funds allow small investors to obtain the benefits of lower

transaction costs in purchasing securities and to take advantage of a reduction

in risk by diversifying their portfolios.

In this chapter we will study why mutual funds have become so popular in

recent years, the types of mutual funds, how mutual funds are regulated, and

finally, how conflicts of interest in the mutual fund industry have led to many

scandals, fines, and indictments since 2001.

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C H A P T E R

The Growth of Mutual Funds

Mutual funds have become the investment vehicle of choice for many investors. At

the beginning of 2010, nearly 16% of all assets in intermediaries were held by mutual

funds. Twenty-five percent of the entire retirement market was invested in mutual

funds by the beginning of 2010, and 45% of all U.S. households held stock in them.

Given the pervasive nature of those intermediaries, we should wonder exactly what

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Part 6 The Financial Institutions Industry

service they provide that has caused them to grow from $292 billion in assets to

almost $10 trillion in assets over just the last 20 years.

The First Mutual Funds

The origins of mutual funds can be traced back to the mid to late 1800s in England

and Scotland. Investment companies were formed that pooled the funds of investors

with modest resources and used the money to invest in a number of different secu-

rities. These investment companies became more popular when they began invest-

ing in the economic growth of the United States, mostly by purchasing American

railroad bonds.

The first fund in which new shares were issued as new money was invested—the

dominant structure seen today—was introduced in Boston in 1824. This fund allowed

for continuous offering of shares, the ability to cash out of the fund at any time, and

a set of restrictions on investments aimed at protecting investors from losses.

The stock market crash of 1929 set mutual fund growth back for several decades

because small investors distrusted stock investments generally and mutual funds

in particular. The Investment Company Act of 1940, which required much more dis-

closure of fees and investment policies, reinvigorated the industry, and mutual funds

began a steady growth.

Benefits of Mutual Funds

There are five principal benefits that attract investors to mutual funds:

1. Liquidity intermediation

2. Denomination intermediation

3. Diversification

4. Cost advantages

5. Managerial expertise

Liquidity intermediation means that investors can convert their investments

into cash quickly and at a low cost. If you buy a CD or a bond, there can be early

redemption penalties or transaction fees imposed if you need your funds before the

securities mature. Additionally, if you bought a $10,000 CD, you must redeem the

whole security even if you only require $5,000 to meet your current needs. Mutual

funds allow investors to buy and redeem at any time and in any amount. Some funds

are designed especially to meet short-term transaction requirements and have no fees

associated with redemption, whereas others are designed for longer-term investment

and may have redemption fees if they are held only a short time.

Denomination intermediation allows small investors access to securities they

would be unable to purchase without the mutual fund. For example, in Chapter 11

we learned that most money market securities are only available in large denomi-

nations, often in excess of $100,000. By pooling money, the mutual fund can purchase

these securities on behalf of investors.