Mutual Funds:An investment primer
What’s a mutual fund?
Where do returns come from?
Is there a strategy that works?
A pop quiz …
1. Mutual funds are primarily owned by:a. Individuals on their ownb. Individuals with retirement
accounts
2. Mutual funds mostly invest in:a. Stocksb. Bondsc. Notes (money market)
3. What have been annual returns (1926-2004):a. Small-cap stocksb. Large-cap stocks c. Corporate bondsd. Treasury bills
4. Warren Buffet predicts that annual stock returns over the next 10 years will be:a. 6.5%b. 9.6%c. 12.3%d. 21.7%
5. Past performance of stock funds generally predicts future returns. a. Yesb. Noc. Only low-performing funds
6. Mutual fund investors say they pay attention more to fees than to performance.a. Trueb. False
7. As a mutual fund investor, you are entitled to:a. Prospectus (before you invest)b. Annual report (showing fund
performance)c. Statements (showing
breakdown of expenses / fees / trading costs)
8. Mutual funds only impose a
sales charge at the time you invest. a. Trueb. False
9. Rate that stock funds sell and replace stock (turnover) in their portfolios:a. 6%b. 56%c. 90%d. 153%
10. What is a no-load fund? a. An unleveraged fundb. A fund without sales chargesc. A fund without trading costsd. A fund without withdrawal fees
11. Think about your own largest mutual fund:a. Your current balanceb. Fund’s investment objectivesc. Fund’s sales charges, expense
ratio, trading costs d. Fund’s performance last year
12. Consider your car/vehicle: a. Its make, model, yearb. Its cost, total miles, safety
rating, gas efficiencyc. You get our point.
ICI 2005 – US Retirement Market
ICI 2004 – US Household Ownership
ICI 2001 – Profile of MF investors
US Households(112 million)
Mutual funds ($9.5 T)
RetirementAccount
48%
55 million own mutual funds(90% have Internet access)
79%(broker)
On own52%
29%(direct)
48%(IRAs)
52%(DC plans)
Stocks 57% Money Mkt 26%Bonds 17%
FR Boston – Oct 2006
Bogle – 60 Years Later (2005)
How are mutual funds organized?
How a mutual fund works
Elect majority
??
services
fees
Mutualfund
[portfolio]
Fund investors
Board of directors
Management firm
Owners
Mutual fund – “tool of capitalism”
“Capitalism ought to be about capturing the benefits of equity investment for those who put up the capital and take the risks.”
Jack Bogle,
founder of Vanguard
“Capturing benefits” - mutual fund gauntlet
(1) Portfolio performanceEquity funds: average = stock market
Can fund managers beat market?
(2) Fund expensesSales load (front-end / back-end)
Marketing fees (from assets - Rule 12b-1)
Management fees (percent of assets)
Portfolio trading costs (brokerage fees, spreads, opportunity costs)
(3) Trading losses (or gains)Marketing touts funds’ past performance
Investors practice “buy high, sell low”
“Capturing benefits” - mutual fund gauntlet
(1) Portfolio performanceEquity funds: average = stock market
Can fund managers beat market?
(2) Fund expensesSales load (front-end / back-end)
Marketing fees (from assets - Rule 12b-1)
Management fees (percent of assets)
Portfolio trading costs (brokerage fees, spreads, opportunity costs)
(3) Trading losses (or gains)Marketing touts funds’ past performance
Investors practice “buy high, sell low”
“Capturing benefits” - mutual fund gauntlet
(1) Portfolio performanceEquity funds: average = stock market
Can fund managers beat market?
(2) Fund expensesSales load (front-end / back-end)
Marketing fees (from assets - Rule 12b-1)
Management fees (percent of assets)
Portfolio trading costs (brokerage fees, spreads, opportunity costs)
(3) Trading losses (or gains)Marketing touts funds’ past performance
Investors practice “buy high, sell low”
Mutual fund performance(the envelope please) …
MF performance
Past decade (annual
averages)
Stock market return 11.1%
Stock fund returns(after expenses)
8.6%
Stock fund investor returns (dollar-weighted returns)
6.2%
Mutual fund expenses = 2.5%
Investor tradinglosses = 2.4%
MF performance
Past decade (annual
averages)
Stock market return 11.1%
Stock fund returns(loads, fees, trading costs)
8.6%
Stock fund investor returns (selection / timing losses)
6.2%
$10,000 (10 years) = $28,651
$10,000 (10 years) = $22,819
$10,000 (10 years) = $18,249
“It’s the costs, dummy”
Role of “independent” directors
“When the managers care about fees and the directors don’t, guess who wins? Negotiating with oneself seldom produces a barroom brawl.”
Warren BuffettValue investor who recommends
that average investor “just index”
Invest $1000/yearfor 40 years …
Effect of costs (fees, trading)
Effects of Costs
$0$100,000$200,000$300,000$400,000$500,000$600,000$700,000
10 20 30 40
Years
Ret
urn
s 5%7%9%11%
What should I do …
Investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
Investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • Of 4800 equity funds, 2000 gone in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
Investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“a good family”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
Investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“ECMH”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
Investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is better”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
Some solutions …
“I’m not your monkey.”
Jon Stewart
Re-tasking fund directors
Actions affecting investor returns
Stock market
Corporate governance:
Attend to proxy voting, governance role
Fund expenses
Fund-manager conflicts:
Reduce advisor fees / prevent abuses
Investor trading
Investor biases:
Address marketing, fund choices, allocations
Re-tasking fund directors
Actions affecting investor returns
Stock market
Corporate governance:
Attend to proxy voting, governance role
Fund expenses
Fund-manager conflicts:
Reduce advisor fees / prevent abuses
Investor trading
Investor biases:
Address marketing, fund choices, allocations
Re-tasking fund directors
Actions affecting investor returns
Stock market
Corporate governance:
Attend to proxy voting, governance role
Fund expenses
Fund-manager conflicts:
Reduce advisor fees / prevent abuses
Investor trading
Investor biases:
Address marketing, fund choices, allocations
The “agitated” mutual fund investor
Actual includes “exchanges” within fund group.
SSRN studies – investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
SSRN studies – investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
SSRN studies – investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
SSRN studies – investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
SSRN studies – investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
Investor cognitive biases
“If investors gobble up all the information that Lipper, Morningstar and publications like this newspaper lay before them, but still insist on ignoring fees and chasing the “hot” fund du jour, who’s to tell them they can’t?”
Holman Jenkins
Wall Street Journal
Editorial - December, 2003
Some solutions …
“I’m not your monkey.”
Jon Stewart
“Best practices” ICI (1999, 2003)
MFDF (2004)
Director independence
Independent chair
“ID” definition
IDs majority
Independent legal counsel
IDs nominate, select
IDs set own pay
D&O insurance
“Lead” ID
No IA execs
2/3
Yes
Yes
Yes
Yes
Yes
Wait 5 yrs
75%
Yes
--
Yes
--
Management arrangements
Independent committee
Review process
Outside consultant
Audit
Executive mtg
--
Review
All info
Yes
Portfolio trading
Seek best execution, MFN fees
“Directed brokerage”
--
--
Yes
Not permit
Portfolio valuation
Standing committee
Stay on top
--
--
Yes
Yes
Conflicts of interest
Directors own funds oversee
Self-evaluation / ID education
Yes
Questionnaire
Yes
Yes
Some solutions …
More disclosure
SEC and NASD / specify disclosure under ERISA
“Informed” investors fend for themselves
Expanded “best practices”Recognize investor biases– “behavioral” advisors
Compensate for biases – fund design, marketing
Federal fiduciary dutiesSpecify functions / informed / enforceable duties
Courts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directorsSelf-regulatory organization (like NASD, PCAOB)
Minimum standards / disciplinary apparatus
Some solutions …
More disclosure
SEC and NASD / specify disclosure under ERISA
“Informed” investors fend for themselves
Expanded “best practices”Recognize investor biases– “behavioral” advisors
Compensate for biases – fund design, marketing
Federal fiduciary dutiesSpecify functions / informed / enforceable duties
Courts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directorsSelf-regulatory organization (like NASD, PCAOB)
Minimum standards / disciplinary apparatus
Some solutions …
More disclosure
SEC and NASD / specify disclosure under ERISA
“Informed” investors fend for themselves
Expanded “best practices”Recognize investor biases– “behavioral” advisors
Compensate for biases – fund design, marketing
Federal fiduciary dutiesSpecify functions / informed / enforceable duties
Courts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directorsSelf-regulatory organization (like NASD, PCAOB)
Minimum standards / disciplinary apparatus
Some solutions …
More disclosure
SEC and NASD / specify disclosure under ERISA
“Informed” investors fend for themselves
Expanded “best practices”Recognize investor biases– “behavioral” advisors
Compensate for biases – fund design, marketing
Federal fiduciary dutiesSpecify functions / informed / enforceable duties
Courts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directorsSelf-regulatory organization (like NASD, PCAOB)
Minimum standards / disciplinary apparatus
Some solutions …
More disclosure
SEC and NASD / specify disclosure under ERISA
“Informed” investors fend for themselves
Expanded “best practices”Recognize investor biases– “behavioral” advisors
Compensate for biases – fund design, marketing
Federal fiduciary dutiesSpecify functions / informed / enforceable duties
Courts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directorsSelf-regulatory organization (like NASD, PCAOB)
Minimum standards / disciplinary apparatus