Mutual Funds – Under the Hood

underthehoodIf you are going to put your life’s savings into mutual funds (most of middle America does), you need to know what’s under the hood.

Invest ten minutes reading this article and you will know more about mutual funds than most of the people selling them.

In the next few minutes we will explore a minute core of the history and evolution of mutual funds, then focus on the fundamentals that are most important to the average investor.

The origin of the mutual fund can be traced back to 17th and 18th century Europe, where the concept of pooling assets was popularized by the Dutch as a means to raise capital for merchant ventures. It provided diversification for investors, and opportunities for smaller investors to participate in ventures. By the mid-nineteenth century, closed end funds had spread to Great Britain and France, taking root in the US in the 1890s.

Prior to 1929, there was no regulation of the securities industry. Companies needing capital issued stock. Brokers sold the stock to investors, often making wild claims and unsubstantiated promises of big profits. Investment companies packaged the stocks from many companies and sold them as mutual funds, often borrowing money from banks (leverage) to purchase more shares than cash raised from investors would allow.

By 1929 there were nineteen open end funds competing with nearly 700 closed end funds. Many of the highly leveraged CEFs were wiped out in the crash of 1929. Open end funds generally offered semiannual share issuance and redemption opportunities and therefore were not highly leveraged as closed end funds were. This also created better liquidity for investors and infusions of cash to keep the funds afloat. This is the form that the retail mutual funds of today operate under.

The stock market crash of 1929 spurred sweeping legislative reform of the securities industry over the next eleven years. Major legislation included;

By 1954, the financial markets had recovered from the crash of 1929. Mutual funds continued to gain popularity. However, it was the creation of the 401k, conceived in 1980 by Ted Benna, then an employee of the Johnson Companies, and now president of the 401k Association, that really set the stage for today’s massive expansion of mutual funds as a “trusted” investment vehicle in the American consumer’s collective consciousness.

In the 1970’s, 80’s, and 90’s, corporate America was facing a huge and growing commitment to pension plans that were crippling profitability. People were living longer and drawing pensions for 30 years or more. At the same time top level managers were trying to figure a way to sock away more compensation for themselves. Enter Ted and his great idea. Rule 401k of the existing IRS tax code gave big companies a tax break for offering a savings plan for employees, but very few took advantage of it. Benna suggested, “why don’t we offer a matching contribution?” The rest is history.

Corporate plan sponsors were anxious to get out from under the cost and fiduciary obligation for their retirement plans, creating a huge opportunity for bundled investment and plan solutions. Investment companies quickly stepped up to the plate with mutual funds. This coincided with the bull markets of the 80’s and 90’s so the investment companies also found a ready market for 529 college savings plans as bull market inflation caused college tuition and other related costs to soar.

According to Jack Bogle, CEO of the Vanguard Group, “around 7 percent of mutual funds “died” each year between 2001 and 2012. That’s up from about 1 percent per year during the 1960s. Assuming (as I do) that such a failure rate will persist over the coming decade, some 2,500 of today’s 4,600 equity funds will no longer exist.” You would think that at that rate mutual funds would disappear from the market. However, new funds come on the scene faster than they are dying. Despite the 2003 mutual fund scandals, the global financial crisis of 2008-2009, and ongoing revenue sharing practices, the story of the mutual fund is far from over. As of this writing, there are about 10,000 mutual funds on the market, including the equity funds Jack spoke of.

What, exactly is a mutual fund. It is a collection of exchange traded securities (stocks, bonds, REITs, business development companies, etc.) that meet the stated portfolio objectives defined by the investment company and fund manager. It allows an individual to pool a small amount of money with other small investors to own shares of the fund, which owns a large number of securities.

What is the primary advantage of a mutual fund? –  A mutual fund provides diversification for investors who can’t afford to own a diversified portfolio of individual exchange traded securities. For example, at the time of this writing, Google sells for over $500/share. IBM and Apple both sell for over $100/share.  The minimum purchase unit for most corporate and municipal bonds is $5000. In order to create a diversified portfolio of 60% individual stocks and 40% individual bonds, an investor would need to invest between $100,00 and $200,000 to get started.

What is the primary disadvantage of a mutual fund? – Retail mutual funds have sales charges, administrative fees, and distribution fees associated with them that add substantially to their cost.  The fee structure is very complicated by design. Retail funds are sold by brokers who’s primary loyalty and legal obligation is to their employer, not their client. Revenue sharing, described in a link above is still practiced by all of the major brokerage firms today. The required disclosures are buried in websites with no links to them or the 300 page electronically delivered fund prospectus. Many investors have twenty or more mutual funds in their investment portfolio, significantly over diversifying and diluting the benefit of superior stock or bond performance.

The following is a breakdown of the most common share classes, their approximate costs, and the rules of play your broker is supposed to abide by. This is part of the actual required disclosure statement for one fund that belongs to a popular fund family. Its sales charges and fees are about average. Other funds’ expenses will be higher or lower than this one.

ShareClasses

 

If you buy A shares, you should make all of your fund purchases inside one fund family, and be absolutely sure you are not paying advisory fees on top of the commission. For example if you are a long-term investor and want to buy the XYZ Growth Fund, you should buy only funds from the XYZ Fund Family. The more you buy, the lower your sales charge is. Once your account reaches $1,000,000, you don’t pay any sales charge for additional investments. However you still pay .95% in annual fund expenses. This is the least expensive way for a disciplined investor to buy and own mutual funds. The rules say that your broker has to wait at least two years to sell those funds and replace them with funds from another fund family, thereby collecting another 5.25%.

B shares have no up-front sales charge, but have a higher 12b-1 fee than A shares for the first six years and a declining back-end sales charge (CDSC) to get out of the fund. After that it converts to an A share.

C shares are sold by broker/advisors that sometimes charge a fee on top of the 1% distribution fee. Both the advisory fee (up to 2%) and the the distribution fee (in this case 1%) are generally shared by the brokerage firm and the advisor for as long as the fund is held.

I shares (institutional) may be sold by fee only or fee based advisors. Most advisor fees will range between 1% and 2%.

R shares, A shares, C shares and sometimes I shares are used in 401k plans. Very often there are multiple classes of R shares (R1, R2, R3, R4, R5) with different distribution charges to accommodate the transfer of employer costs for operating the plan (TPA and other administrative costs) to employees and pay the broker who sets up the 401k.