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 own
b. Individuals with retirement
accounts
2. Mutual funds mostly invest in:
a. Stocks
b. Bonds
c. Notes (money market)
3. What have been annual
returns (1926-2004):
a.
b.
c.
d.
Small-cap stocks
Large-cap stocks
Corporate bonds
Treasury bills
4. Warren Buffet predicts that
annual stock returns over the
next 10 years will be:
a.
b.
c.
d.
6.5%
9.6%
12.3%
21.7%
5. Past performance of stock funds
generally predicts future returns.
a. Yes
b. No
c. Only low-performing funds
6. Mutual fund investors say they
pay attention more to fees than
to performance.
a. True
b. 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. True
b. False
9. Rate that stock funds sell and
replace stock (turnover) in their
portfolios:
a.
b.
c.
d.
6%
56%
90%
153%
10. What is a no-load fund?
a.
b.
c.
d.
An unleveraged fund
A fund without sales charges
A fund without trading costs
A fund without withdrawal fees
11. Think about your own largest
mutual fund:
a. Your current balance
b. Fund’s investment objectives
c. Fund’s sales charges, expense
ratio, trading costs
d. Fund’s performance last year
12. Consider your car/vehicle:
a. Its make, model, year
b. Its cost, total miles, safety
rating, gas efficiency
c. You get our point.
US Households
(112 million)
55 million own mutual funds
(90% have Internet access)
On own
52%
79%
(broker)
29%
(direct)
Retirement
Account
48%
48%
(IRAs)
52%
(DC plans)
Mutual funds ($9.5 T)
Stocks 57%
ICI 2005 – US Retirement Market
ICI 2004 – US Household Ownership
ICI 2001 – Profile of MF investors
Bonds 17%
Money Mkt 26%
FR Boston – Oct 2006
Bogle – 60 Years Later (2005)
How are mutual funds organized?
How a mutual fund works
Fund investors
Elect majority
Owners
Board of
directors
??
Mutual
fund
[portfolio]
services
fees
Management firm
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 performance
Equity funds: average = stock market
Can fund managers beat market?
(2) Fund expenses
Sales 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 performance
Equity funds: average = stock market
Can fund managers beat market?
(2) Fund expenses
Sales 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 performance
Equity funds: average = stock market
Can fund managers beat market?
(2) Fund expenses
Sales 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 trading
losses = 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 Buffett
Value investor who recommends
that average investor “just index”
Invest $1000/year
for 40 years …
Effect of costs (fees, trading)
Returns
Effects of Costs
$700,000
$600,000
$500,000
$400,000
$300,000
$200,000
$100,000
$0
5%
7%
9%
11%
10
20
30
Years
40
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
•
•
Investors pursue lower loads and
commissions, not operating fees
Among index funds, “name brand” wins
•
•
Info overload leads to worse decisions
Investors notice fees when buy, not hold
“disclosure salve”
“more is less”
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
•
•
Investors pursue lower loads and
commissions, not operating fees
Among index funds, “name brand” wins
•
•
Info overload leads to worse decisions
Investors notice fees when buy, not hold
“disclosure salve”
“more is less”
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
•
•
Investors pursue lower loads and
commissions, not operating fees
Among index funds, “name brand” wins
•
•
Info overload leads to worse decisions
Investors notice fees when buy, not hold
“disclosure salve”
“more is less”
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
•
•
Investors pursue lower loads and
commissions, not operating fees
Among index funds, “name brand” wins
•
•
Info overload leads to worse decisions
Investors notice fees when buy, not hold
“ECMH”
“more is less”
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
•
•
Investors pursue lower loads and
commissions, not operating fees
Among index funds, “name brand” wins
•
•
Info overload leads to worse decisions
Investors notice fees when buy, not hold
“disclosure salve”
“more is better”
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
•
•
Investors pursue lower loads and
commissions, not operating fees
Among index funds, “name brand” wins
•
•
Info overload leads to worse decisions
Investors notice fees when buy, not hold
“disclosure salve”
“more is less”
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
•
•
Investors pursue lower loads and
commissions, not operating fees
Among index funds, “name brand” wins
•
•
Info overload leads to worse decisions
Investors notice fees when buy, not hold
“disclosure salve”
“more is less”
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
•
•
Investors pursue lower loads and
commissions, not operating fees
Among index funds, “name brand” wins
•
•
Info overload leads to worse decisions
Investors notice fees when buy, not hold
“disclosure salve”
“more is less”
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
•
•
Investors pursue lower loads and
commissions, not operating fees
Among index funds, “name brand” wins
•
•
Info overload leads to worse decisions
Investors notice fees when buy, not hold
“disclosure salve”
“more is less”
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
•
•
Investors pursue lower loads and
commissions, not operating fees
Among index funds, “name brand” wins
•
•
Info overload leads to worse decisions
Investors notice fees when buy, not hold
“disclosure salve”
“more is less”
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”
Director
independence
Independent chair
“ID” definition
IDs majority
Independent legal counsel
IDs nominate, select
IDs set own pay
D&O insurance
Independent committee
Management
Review process
arrangements
Outside consultant
ICI
MFDF
(1999, 2003)
(2004)
“Lead” ID
No IA execs
2/3
Yes
Yes
Yes
Yes
Yes
Wait 5 yrs
75%
Yes
-Yes
--
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 duties
Specify functions / informed / enforceable duties
Courts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directors
Self-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 duties
Specify functions / informed / enforceable duties
Courts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directors
Self-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 duties
Specify functions / informed / enforceable duties
Courts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directors
Self-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 duties
Specify functions / informed / enforceable duties
Courts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directors
Self-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 duties
Specify functions / informed / enforceable duties
Courts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directors
Self-regulatory organization (like NASD, PCAOB)
Minimum standards / disciplinary apparatus