Financial Markets and Institutions (2-downloads)

Shareholders

Mutual Fund

Board of Directors

Oversees the fund’s activities, including approval of the contract with

the management company and certain other service providers 

Investment

Adviser

Manages the

fund’s portfolio

according to

the objectives

and policies

described in

the fund’s

prospectus.

Principal

Underwriter

Sells fund

shares either

directly to

the public or

through other

firms (e.g.

broker dealers).

Independent

Public

Accountant

Certifies the

fund’s

financial

statements.

Administrator

Oversees

performance of

other companies

that provide

services to the

fund and ensures

that the fund’s

operations comply

with applicable

federal

requirements.

Transfer Agent

Executes

shareholder

transactions,

maintains records

of transactions and

other shareholder

account activity,

and sends account

statements and

other documents

to shareholders.

Custodian

Holds the

fund’s assets,

maintaining

them

separately

to protect

shareholder

interests and

reconciling the

fund’s holdings

against the

custodian’s

records.

F I G U R E   2 0 . 3

The Organizational Structure of a Mutual Fund

Source: Investment Company Institute, 2010 Investment Company Fact Book, 50th Ed. (Washington DC: ICI). Reprinted

with permission.

In addition to the investment advisors, the fund will contract with other firms

to provide additional services. These will include underwriters, transfer agents, and

custodians. Contracts will also be arranged with an independent public accountant.

Large funds may arrange for some of these functions to be done in-house, whereas

other funds will use all outside companies. Figure 20.3 shows the organizational struc-

ture of a mutual fund.

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Investment Objective Classes

Four primary classes of mutual funds are available to investors. They are (1) stock

funds (also called equity funds), (2) bond funds, (3) hybrid funds, and (4) money

market funds. Figure 20.4 shows the distribution of assets among these types of

funds. The largest class is the equity funds, followed by the money market, bond, and

hybrid funds.

Equity Funds

Equity funds share a common theme in that they all invest in stock. After that, they

can have very different objectives. The three classes reported by the Investment

Company Institute are capital appreciation funds, world funds, and total return funds.

Capital appreciation funds are the largest, with about 39% of all mutual fund assets.

These funds seek rapid capital appreciation (increases in share prices) and are not

concerned with dividends. Many of these funds are relatively risky in that the fund

managers are attempting to select companies incurring rapid growth. For example,

many capital appreciation mutual funds invested heavily in high technology and

Internet stocks during the 1990s.

Total return funds represent about 28% of total mutual fund assets. The goal

of these funds is to seek a combination of current income and capital appreciation.

They will include both mature firms that are paying dividends and growth companies

that are expected to post large stock price increases. Total return funds are expected

to be less risky than capital appreciation funds since they will include more large

established firms. This was borne out in 2000 when capital appreciation funds lost

16.5% of their assets and total return funds only lost 5.7%.

World equity funds invest primarily in stocks of foreign companies. These funds

allow investors easy access to international diversification. Many financial planners

recommend that investors hold at least a small portion of their investments in foreign

stocks. These world funds provide the primary vehicle.

Chapter 20 The Mutual Fund Industry

497

Equity

$4.96 Trillion

45%

Money Market

$3.32 Trillion

29%

Bond Funds

$2.21 Trillion

20%

Hybrid

$640.75 Billion

6%

F I G U R E   2 0 . 4

Distribution of Assets Among Types of Mutual Funds

Data Source: Investment Company Institute, 2010 Investment Company Fact Book, 50th ed. (Washington,

DC: ICI), p. 126. 

www.icifactbook.org/index.html

.

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498

Part 6 The Financial Institutions Industry

State Municipal

$1.071 Trillion

20%

Government

$803 Billion

15%

Strategic Income

$1.001 Trillion

18%

National Municipal

$679 Billion

13%

Corporate

$868 Billion

16%

World

$419 Billion

8%

High Yield

$571 Billion

10%

F I G U R E   2 0 . 5

Assets Invested in Different Types of Bond Mutual Funds

Data Source: Investment Company Institute, 2010 Investment Company Fact Book, 50th ed. (Washington, DC: ICI), 

p. 131. 

www.icifactbook.org/index.html

.

The three types of equity funds presented here oversimplify the range of stock

mutual funds available to investors. For example, the Vanguard family of mutual funds

offers 62 different stock funds. Each one differs in its stated goals. Some hold stock

from specific industries; others hold stock with certain historical growth rates. Others

are chosen by their PE ratio. Mutual fund companies try to offer a fund that will

appeal to every investor’s needs.

Bond Funds

Figure 20.5 shows the major types of bond funds tracked by the Investment Company

Institute. Strategic income bonds are the most popular and invest in a combination

of U.S. corporate bonds to provide a high level of current income. The quality of the

bonds in these funds will often be lower than in some other classes, but their yields

will be higher. Investors are trading safety for greater returns. Corporate bond funds,

the next most popular fund type, invest primarily in high-grade corporate bonds.

Government bonds are also popular. These are essentially default risk-free, but will

have relatively low returns. The state and national municipal (muni) bonds are tax-free.

Bonds are not as risky as stocks, and so it is not usually as important that

investors diversify across a large number of different bonds. Additionally, it is rela-

tively easy to buy and sell bonds through the secondary market. As a result, it is

not surprising that bond mutual funds hold only about a third of the assets held by

stock mutual funds. Still, many investors value the liquidity intervention and auto-

matic reinvestment features provided by bond mutual funds.

Hybrid Funds

Hybrid funds combine stocks and bonds into one fund. The idea is to provide an invest-

ment that diversifies across different types of securities as well as across different

issuers of a particular type of security. Thus, if an investor found a hybrid fund that

held the percentage of stocks and bonds he wanted, he could own just one fund

instead of several. Despite this apparent convenience, most investors still prefer to

choose separate funds. Only about 5% of all mutual fund accounts are hybrid accounts.

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Chapter 20 The Mutual Fund Industry

499

Money Market Funds

Money market mutual funds (MMMFs) have existed since the early 1970s; however,

the low market interest rates before 1977 (which were either below or just slightly

above the Regulation Q ceiling of 5.25% to 5.5%) kept them from being particularly

advantageous relative to bank deposits. In 1978, Merrill Lynch recognized that it could

provide better service to its customers if it offered an account that customers could

use to warehouse money. Prior to the introduction of MMMFs as a small-investor

account, customers had to bring in checks to the brokerage house when they wanted

to invest and had to pick up checks when they sold securities. Customers who had

MMMF accounts, however, could simply direct the broker to take funds out of this

account to buy stocks or to deposit funds in this account when they sold securities.

Initially, Merrill Lynch did not look on the MMMF as a major source of income.

In the early 1980s, inflation and interest rates skyrocketed. Regulation Q

restricted banks from paying more than 5.25% in interest on savings accounts. With

interest rates in the money markets exceeding 15%, investors flocked to MMMFs.

Figure 20.6 shows the growth of MMMFs since 1975.

All MMMFs are open-end investment funds that invest only in money market

securities. Most funds do not charge investors any fee for purchasing or redeeming

shares. The funds usually have a minimum initial investment of $500 to $2,000. The

funds’ yields depend entirely on the performance of the securities purchased.

An important feature of MMMFs is that many have check-writing privileges. They

often do not charge a fee for writing checks or have any minimum check amount

as long as the balance in the account is above the stated level. This convenience, along

with market interest rates, makes the accounts very popular with small investors.

Investors often take their money out of federally insured banks and thrifts and put

it into uninsured MMMFs. An important question is why they are so willing to take this

extra level of risk. The reason is that the extra risk has historically been really very

small. The money invested in MMMFs is in turn invested in money market instruments.

Commercial paper and certificates of deposit are by far the largest component of these

funds, followed by U.S. Treasury securities and repurchase agreements. Figure 20.7

shows the distribution of money market fund assets. Because the risk of default on

these securities was thought to be very low, the risk of MMMFs was considered very

low. Investors recognized this and so were willing to abandon the safety of banks for

higher returns.

This confidence was shaken during the credit crisis when there was a short

period when mutual funds were unable to redeem their holdings of commercial paper.

Even though commercial paper is short-term and issued by typically strong compa-

nies, the near panic situation in the markets caused the market for these securities

to evaporate. The day after Lehman Brothers Holdings, Inc., declared bankruptcy

on September 15, 2008, the Reserve Primary Fund “broke the Buck” by failing to

redeem money market accounts at the $1.00 NAV. This initiated a run around the

world on money market funds with rapid withdrawals threatening the liquidity of hun-

dreds of other funds. Two days later the Treasury announced a Temporary Guarantee

Program for money market funds, and the Fed agreed to finance the purchase of

asset-backed commercial paper from money market funds. The effect of these actions

restored confidence and by October of 2008, investors had added $149 billion in

new cash. This trend continued such that by January 2009, total assets in MMMFs

were nearly $4 trillion, their highest level up to that date. Investors were moving

out of stock, bond, and hybrid funds to the safety of the money market account.

Access the most recent

statistics on the net assets

of money market mutual

funds at 

www.ici.org

.

G O   O N L I N E

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Part 6 The Financial Institutions Industry

Index Funds

A special kind of mutual fund that does not fit any of the classes discussed previously,

yet which represents an alternative investment style, is the index fund. Traditional

funds employ investment managers who select stocks and bonds for the fund’s port-

folio. If we believe the lessons about market efficiency discussed in Chapter 6, we

would conclude that investment managers are not likely to pick stocks any better

than could a dart thrown at the stock pages of the Wall Street Journal. If investment

managers are not superior stock pickers, then we might ask why one should pay them

a fee to provide a service that may not have any marginal benefit.

0

100

200

300

400

500

600

700

800

900

1,000

1,100

1,200

1,300

1,400

1,500

1,600

1,700

1,800

1,900

2,100

2,300

1995 1996 1997

1994

1993

1992

1991

1990

1985

1980

1975

Net Assets

($ billions)

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

2,700

3,100

3,300

2,000

2,200

2,500

2,900

2,600

3,000

3,200

2,400

2,800

F I G U R E   2 0 . 6

Net Assets of Money Market Mutual Funds

Data Source: Investment Company Institute, 2010 Investment Company Fact Book, 50th ed. (Washington, DC: ICI), p. 160. 

www.icifactbook.org/index.html

.

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Chapter 20 The Mutual Fund Industry

501

Repurchase

Agreements

8.6%

T Bills 2.7%

Corp Notes

6.2%

Commercial Paper

27.6%

Other U.S.

Securities

11.2%

Other

securities

12.8%

Certificates of Deposit

30.9%

F I G U R E   2 0 . 7

Average Distribution of Money Market Fund Assets, 2010

Data Source: Investment Company Institute, 2010 Investment Company Fact Book, 50th ed. (Washington,

DC: ICI), p. 166. 

www.icifactbook.org/index.html

.

Many investors want the benefits of mutual fund investing without the cost of pay-

ing for investment manager services. The answer is the index fund. An index fund con-

tains the stocks in an index. For example, the mammoth Vanguard S&P 500 index fund

contains the 500 stocks in that index. The stocks are held in a proportion such that

changes to the fund value closely match changes to the index level. There are many

other index funds available that mimic the behavior of various stock and bond indexes.

Index funds do not require managers to choose securities. As a result, these funds

tend to have far lower fees than other actively managed funds. Some financial experts

even argue that these funds will outperform most fund managers because they will

ignore the fads, trends, emotions, and hysteria that often cloud investment adviser

and individual investor judgment. In an interesting admission, the recently retired

founder and former CEO of the Vanguard Group of mutual funds, John Bogle, stated

he was an “index investor.”

1

Fee Structure of Investment Funds

Originally, most shares of mutual funds were sold by brokers who received a commis-

sion for their efforts. Because this commission was paid at the time of the purchase

and immediately subtracted from the redemption value of the shares, these funds

were called load funds. If the fee is charged when the funds are deposited, it is a

front-end load. Most front-end loads are between 1% to 2%, but some exceed 6%.

If a fee is charged when funds are taken out (usually a declining fee over five years),

it is a deferred load. The primary purpose of loads is to provide compensation for

sales brokers. An alternative motivation, especially for deferred-load funds, is to

discourage early withdrawal of deposits.

1

Keynote speech by John Bogle, founder and former CEO of the Vanguard Group, before the American

Business Editors and Writers Personal Finance Workshop, Denver, Colorado, October 27, 2003.

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502

Part 6 The Financial Institutions Industry

Beginning in the 1980s, funds that did not charge a direct load (or fee) appeared.

These are called no-load funds. Most no-load funds can be purchased directly by

individual investors, and no middleman is required. Currently about 55% of equity

funds and 65% of bond funds are no load. Many investors have realized that when the

initial deposit is immediately reduced, it can take a long time to catch up to the

returns offered by no-load funds. The shares of front-end loaded funds are termed

Class A shares. Shares in deferred-load funds are termed Class B shares. Class C

shares are issued for no-load funds.

Regardless of whether a load is charged, all mutual fund accounts are subject

to a variety of fees. One of the primary factors that an investor should consider before

choosing a mutual fund is the level of fees the fund charges. The fees are taken out

of portfolio income before it is passed on to the investor. Since the investor is not

directly charged the fees, many will not realize that they have even been subtracted.

The usual fees charged by mutual funds are the following:

• A contingent deferred sales charge imposed at the time of redemption is an

alternative way to compensate financial professionals for their services. This

fee typically applies for the first few years of ownership and then disappears.

• A redemption fee is a back-end charge for redeeming shares. It is

expressed as a dollar amount or a percentage of the redemption price.

• An exchange fee may be charged when transferring money from one fund

to another within the same fund family.

• An account maintenance fee is charged by some funds to maintain low bal-

ance accounts.

• 12b-1 fees, if any, are deducted from the fund’s assets to pay marketing and

advertising expenses or, more commonly, to compensate sales professionals.

By law, 12b-1 fees cannot exceed 1% of the fund’s average net assets per year.

Clearly, there are many opportunities for mutual fund managers to charge

investors for the right to invest. Investors should very carefully evaluate a mutual

fund’s fee structure before investing, since these fees can range from 0.25% to as

much as 8% per year. No research supports the argument that investors get better

returns by investing in funds that charge higher fees. On the contrary, most high-

fee mutual funds fail to do as well, after expenses, as low-fee funds.

Over the last 20 years, competition within the mutual fund industry has produced

substantially lower costs. Between 1980 and 2008, the average total shareholder cost

of equity mutual funds decreased by more than 57%. The cost of bond funds dropped

by 63%. One factor undoubtedly contributing to this reduction is the requirement

by the SEC that mutual funds clearly disclose all fees and costs that investors will

incur. The SEC further requires mutual funds to include in their prospectus a stan-

dardized sample account where $10,000 is invested for one, three, five, and ten years.

The analysis shows investors exactly what fees they will be subject to if they choose

the fund. The fee disclosure requirement makes it very easy for investors to compare

funds, and therefore increases competition among them.

Regulation of Mutual Funds

Mutual funds are regulated under four federal laws designed to protect investors. The

Securities Act of 1933 mandates that funds make certain disclosures. The Securities

Exchange Act of 1934 set out antifraud rules covering the purchase and sale of fund

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Chapter 20 The Mutual Fund Industry

503

shares. The Investment Company Act of 1940 requires all funds to register with the

SEC and to meet certain operating standards. Finally, the Investment Advisers Act

of 1940 regulates fund advisers.

As part of this government regulation, all funds must provide two types of doc-

uments free of charge: a prospectus and a shareholder report. A mutual fund’s

prospectus describes the fund’s goals, fees and expenses, and investment strate-

gies and risks; it also gives information on how to buy and sell shares. The SEC

requires a fund to provide a full prospectus either before an investment or together

with the confirmation statement of an initial investment.

Annual and semiannual shareholder reports discuss the fund’s recent perfor-

mance and include other important information, such as the fund’s financial state-

ments. By examining these reports, an investor can learn if a fund has been effective

in meeting the goals and investment strategies described in the fund’s prospectus.

In addition, investors are sent a yearly statement detailing the federal tax sta-

tus of distributions received from the fund. Mutual fund shareholders are taxed on

the fund’s income directly, as if the shareholders held the underlying securities them-

selves. Similarly, any tax-exempt income received by a fund is generally passed on

to the shareholders as tax exempt.

Investment funds are run by brokerage houses and by institutional investors, who

now control over 50% of the outstanding stock in the United States. Over 70% of

the total daily volume in stocks is due to institutions initiating trades. Many of the

mutual funds are run by brokerage houses; others are run by independent investment

advisers. Because of the volume of stock controlled by these investors, there is

tremendous competition for their business. This has led to significant cost cutting

and to the proliferation of alternative methods of trading. For example, computer-

ized trading that eliminates the broker from the transaction accounts for a growing

percentage of the activity in stocks.

Mutual funds are the only companies in America that are required by law to have

independent directors. The SEC believes that independent directors play a critical

role in the governance of mutual funds. In January 2001, the SEC adopted substan-

tive rule amendments designed to enhance the independence of investment company

directors and provide investors with more information to assess directors’ indepen-

dence. These rules require that:

• Independent directors constitute at least a majority of the fund’s board of

directors.

• Independent directors select and nominate other independent directors.

• Any legal counsel for the fund’s independent directors be an independent

legal counsel.

In addition, SEC rules require that mutual funds publish extensive information

about directors, including their business experience and fund shares held. This system

of overseeing the interests of mutual fund shareholders has helped the industry avoid

systemic problems and contributed significantly to public confidence in mutual funds.

Hedge Funds