The FundIndustry

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The FundIndustry

How Your Money Is Managed

Second Edition

ROBERT POZEN ANDTHERESA HAMACHER

Foreword byRobert J. Shiller

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Copyright © 2015 by Robert Pozen and Theresa Hamacher. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

The First edition of The Fund Industry was published by John Wiley & Sons, Inc., in 2011.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data

Pozen, Robert C.The fund industry : how your money is managed / Robert Pozen and Theresa Hamacher. –

2nd Edition.pages cm. – (Wiley finance series)

Includes index.ISBN 978-1-118-92994-0 (cloth) – ISBN 978-1-118-92995-7 (ePub) –

ISBN 978-1-118-92996-4 (ePDF) 1. Mutual funds–United States. 2. Mutual funds.I. Hamacher, Theresa. II. Title.HG4930.P63 2015332.63 ′27–dc23

2014031897

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

Contents

Foreword Robert J. Shiller xi

Preface to the Second Edition xiii

Acknowledgments xvii

SECTION ONEAn Investor’s Guide to Mutual Funds

CHAPTER 1Investing through Mutual Funds 3

Advantages and Disadvantages of Mutual Funds 4History and Growth 8Regulators and Industry Associations 16Chapter Summary 22Notes 23

CHAPTER 2How Mutual Funds Work 27

Buying and Selling Fund Shares 28The Pass-Through Tax Status of Mutual Funds 31A Virtual Corporation 34Ethical Standards 41Alternatives to Mutual Funds 46Chapter Summary 52Notes 53

CHAPTER 3Researching Funds: The User Guides 57

Mutual Funds and Disclosure 57The Summary Prospectus 62

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vi CONTENTS

Beyond the Summary Prospectus 69Using the User Guides 75Chapter Summary 76Notes 77

CHAPTER 4Comparing Mutual Funds 79

Delineating Your Own Investment Objectives 80Evaluating Performance 83The Taxonomy of Mutual Funds 88Chapter Summary 101Notes 102

CHAPTER 5The Cost of Fund Ownership 105

The Focus on Fund Expenses 105Distribution Expenses 109Operating Expenses 117The Management Fee 119The Active versus Passive Debate 128Chapter Summary 133Notes 134

SECTION TWOMutual Fund Portfolio Management

CHAPTER 6Portfolio Management of Stock Funds 139

Stock Research 140Putting It All Together: Managing a Stock Fund 151Chapter Summary 164Notes 165

CHAPTER 7Portfolio Management of Bond Funds 169

Bond Fund Holdings 169Putting It All Together: Managing a Bond Fund 181Chapter Summary 187Notes 188

CONTENTS vii

APPENDIX TO CHAPTER 7Funds and Derivatives 191

Uses of Derivatives in Funds 192Regulation of Derivatives in Funds 194Notes 197

CHAPTER 8Portfolio Management of Money Market Funds 199

Money Market Funds and the Financial System 200Rule 2a-7 202Money Market Fund Holdings 210Putting It All Together: Managing a Money Market Fund 214Chapter Summary 217Notes 218

CHAPTER 9Implementing Portfolio Decisions: Trading 223

The Importance of Trading 224The U.S. Stock Markets 225The Role of the Mutual Fund Trader 236Trading in Bond Funds 243Chapter Summary 245Notes 246

CHAPTER 10Mutual Funds as Stockholders 249

Mutual Funds and the Proxy Voting Process 249Proxy Voting by Mutual Funds 253Activism and Mutual Funds 258Current Issues in Proxy Voting 264Proxy Voting Outside the United States 266Chapter Summary 268Notes 269

SECTION THREESales and Operations

CHAPTER 11Retail Distribution 275

What Sells Mutual Funds? 276Distribution Channels 277

viii CONTENTS

Fund Platforms 284Distribution Strategy 290Chapter Summary 295Notes 296

CHAPTER 12Retirement Saving through 401(k) Plans 301

The Benefits of Tax-Deferred Saving 302History and Growth of 401(k) Plans 304Contributions to 401(k) Plans 310Investment Options in 401(k) Plans 312Target Date Funds 316Plan Administration 319Chapter Summary 320Notes 321

CHAPTER 13Other Retirement Planning Options 325

Individual Retirement Accounts 326Variable Annuities 332The Future of Retirement Income in the United States 334Chapter Summary 339Notes 339

CHAPTER 14Fund Operations 343

The Transfer Agent 343Fund Accounting 355Investment Operations 366Chapter Summary 370Notes 372

SECTION FOURBeyond Traditional Funds

CHAPTER 15Exchange-Traded Funds 377

A Brief History 377Advantages and Disadvantages 380Legal Structure 381

CONTENTS ix

Operations 384Portfolio Holdings 387The Future of ETFs 393Chapter Summary 394Notes 395

CHAPTER 16Hedge Funds 399

Traditional Hedge Funds 400Traditional Hedge Fund Investors 415The New Hedge Funds: Liquid Alternatives 419Chapter Summary 423Notes 424

SECTION FIVEThe Internationalization of Mutual Funds

CHAPTER 17Cross-Border Investing 433

The Growth in Cross-Border Investing 433Advantages and Risks of Investing Overseas 437Operational Challenges of Investing Overseas 440Putting It All Together: Managing a Global or International

Fund 444Chapter Summary 448Notes 449

CHAPTER 18Cross-Border Asset Gathering 451

The Global Market for Investment Funds 451Models for a Global Fund Business 459The UCITS Model 464Chapter Summary 473Notes 474

APPENDIX TO CHAPTER 18Gathering Fund Assets through Retirement Plans 477

Chile’s Retirement System 480Singapore’s Retirement System 483Notes 487

x CONTENTS

About the Companion Website 489

About the Authors 491

Index 493

Foreword

I like this book because it gives a real understanding of the mutual fundindustry, the provider of the most important investing vehicles for most

people. Intelligent investing requires just the kind of understanding that isgiven in this book. One needs to know where the returns are coming fromand how the mutual fund’s strategy relates to one’s own issues. One shouldnot rely exclusively on others’ advice, or simple tabulations of past perfor-mance of mutual funds, or predictions of future performance. The actualrecord of such predictions ranges from uneven to wrong.

The book clearly explains the different types of mutual funds and howthey are each run to achieve their objectives. It has a particularly goodchapter on how investors can utilize fund measurement services, like Lipperor Morningstar, which apply their own methodologies to analyze fundperformance. Their analyses can be easily misused by investors who do notknow what they are doing.

The second edition has expanded coverage of the newest and mostsought-after products in the industry today—with separate chapters onexchange-traded funds and hedge funds. And it reviews the spectaculargrowth of the liquid alternative funds.

The book goes on to identify the key strategies that fund investors andmanagers can adopt to optimize their tax efficiency withmutual funds. Theseinclude tax-advantaged vehicles for retirement planning, college savings, andcharitable giving. Taxation matters immensely for investment performance,and yet many investors neglect to consider properly how their own specificsituation should impact their choice of mutual funds.

In addition, the book has two chapters on international investing.One explores the special challenges of buying securities in foreign markets.The other discusses the barriers faced by U.S. managers trying to selltheir funds to foreign investors. Many investors are not well diversifiedinternationally. The information here can help them feel more comfortabletaking the plunge into the world market.

In the process, the book analyzes many of the important policy ques-tions that are much debated in the industry as well as academia and thepress. Are the expenses of mutual funds too high? Are the independent direc-tors effective watchdogs for fund shareholders? Are mutual funds as large

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xii FOREWORD

investors holding the executives of public companies accountable? Are indexfunds superior to actively managed funds—in which asset categories?

The second edition continues to be written in a straightforward andengaging manner for nonexperts, with helpful summaries at the end of eachchapter. Instead of taxing the reader, the second edition expands the Internetsupplements on technical subjects like derivatives and bond terms.

In sum, I recommend this book not only for fund investors andthose working in the fund industry—and those thinking about workingthere—but also for students of financial institutions and service providersto the industry: accountants, lawyers, and even journalists.

Robert J. ShillerSterling Professor of Economics at Yale UniversityWinner of the 2013 Nobel Prize in Economic Sciences,together with Eugene Fama and Lars Peter Hansen of theUniversity of Chicago

Preface to the Second Edition

We were surprised by howmuch has changed in the fund industry over thepast four years. When we submitted the manuscript to the first edition

in the summer of 2010, we thought we had a pretty good picture of whatthe business would look like in the post-credit-crisis world. By that time, thecollapse of Lehman Brothers was an old story, and the Dodd-Frank financialreform was the new law of the land.

But, as usual, reality has a way of defying expectations. The speed andthe magnitude of the changes were breathtaking; for example, mutual fundsand hedge funds were converging at a much faster pace than we anticipated.And there were a host of smaller changes, like the adoption of a pay-to-playrule by the SEC and the development of a new data source on distributionthrough intermediaries—the latter resulting from the explosion in the useof omnibus accounts for shareholder recordkeeping.

To capture this new reality, we needed to make some significant changesin this book. This second edition has:

■ Expanded chapter on ETFs. Now that exchange-traded funds are10 percent of the industry’s total assets, we felt that they deserveda chapter of their own, which gave us more room to review theirinvestment approaches and the outlook for their future.

■ New chapter on hedge funds. We moved the discussion of hedge fundsto a separate chapter as well, given their continued rapid growth.This chapter was entirely revamped to reflect the major changes inprivate fund regulation wrought by Dodd-Frank and the JOBS Act andto add a discussion of the melding of hedge funds and mutual funds ina category called liquid alternatives.

■ Increased coverage of retirement. As the importance of retirement sav-ings programs to industry growth has increased, so has this book’s cov-erage of them. Our single chapter on retirement planning in the UnitedStates has become two in this edition, with expanded discussions of tar-get date funds and annuities. And the final chapter now has an appendixthat focuses on retirement systems in two countries.

■ Chapter dedicated to fund expenses. The cost of owning a mutual fundcontinues to be an area of focus for investors, regulators, and industryobservers. We’ve created a separate chapter on expenses from material

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xiv PREFACE TO THE SECOND EDITION

that had previously been sprinkled throughout the book, to provide acomprehensive view of fund fees and the debate surrounding them.

■ Coverage of derivatives. By popular demand, we’ve added an introduc-tion to derivatives and an overview of their use in funds.

■ Complete updates. And we’ve thoroughly updated all of the otherchapters to reflect the latest data, commentary, regulations, andtrends—from the revised Morningstar classification system for fixedincome funds to the adoption of AIFMD in Europe to the debate overhigh-frequency trading.

To make room for all of this new matter, we’ve taken advantage of theInternet and published some sections there. The companion website for thisbook contains:

■ A new introduction to derivatives in three separate articles covering“The Basics,” “Futures, Forwards, and Swaps,” and “Options andCredit Default Swaps.”

■ The overview of fixed income securities, titled “Bond Basics.”■ Supplemental material referenced throughout the book.■ Footnotes to the text, which have been expanded to provide a compre-hensive reference to sources, including legal citations.

Teachers will find materials just for them online at www.wiley.com/go/fundindustry2, including PowerPoint summaries for classroom use.

Yet, despite all the changes, the essence of this book remains thesame: The Fund Industry is written for anyone who’d like to know howtheir money is managed. It’s a practical guide, going behind the scenes atfund management companies to explain how they select investments forfund portfolios, sell fund shares around the globe, and provide serviceto fund shareholders.

It’s a complex industry, offering thousands of funds—governed bydetailed laws and regulations—through intermediaries, direct sales, andretirement plans. And it’s a very important industry, responsible for almosta quarter of the savings that Americans rely on to fund the purchase of ahome, a comfortable retirement, or a college education.

We’ve worked in the industry for a combined total of 57 years, andwe’re honored to have the opportunity to share our knowledge of investmentmanagement with those who work in the industry, oversee its activities, andinvest in mutual funds.

This book is divided into five sections:

1. Section One: An Investor’s Guide to Mutual Funds looks at funds froman investor’s perspective. We review the advantages and disadvantages of

PREFACE TO THE SECOND EDITION xv

mutual funds, describe how they work, and explain how investors cangather research for potential fund investments. We explore the differentcategories of mutual funds and review how investors might choose fundswithin each. We wrap up with a review of the costs of owning a mutualfund.

2. Section Two: Mutual Fund Portfolio Management examines how fundsmanage their investments. We discuss portfolio management in stock,bond, and money market funds and then examine how funds implementinvestment decisions through trading. We conclude with an overviewof how mutual funds exercise their responsibilities as substantial stockinvestors. An appendix provides an overview of the use of derivatives infunds.

3. Section Three: Sales and Operations examines two other critical aspectsof the mutual fund business: the sale of mutual fund shares to investorsand fund operations. We begin by surveying retail sales through inter-mediaries and directly to consumers through the direct channel. Thenext two chapters discuss the use of funds in 401(k) plans and in otherretirement savings vehicles, namely individual retirement accounts andannuities. The last chapter in the section reviews funds’ client serviceand portfolio recordkeeping operations.

4. Section Four: Beyond Traditional Funds examines two fast-growingalternatives to traditional mutual funds: exchange-traded funds, orETFs, and hedge funds. In separate chapters, we look at the regulationsgoverning them, their investor base, their investment approaches, andtheir prospects for the future.

5. Section Five: The Internationalization of Mutual Funds opens with alook at the investment and operational issues faced by U.S. mutual fundsinvesting abroad. We then examine the special challenges involved in dis-tributing funds around the world, with a focus on the European Union’ssuccessful model for cross-border distribution.We close with an appendixthat reviews two retirement systems outside the United States and Europeand the role of mutual funds within them.

Acknowledgments

We’d like to thank the following subject matter experts who took the timeto provide background information and review drafts. They are:

Chapter 3 on disclosure documents: Judy Hogan.

Chapter 7 on bond funds: Jerry Webman.

Chapter 8 on money market funds: Jane Heinrichs.

Chapter 9 on trading: Daniel Farrell.

Chapter 10 on proxy voting: Matthew R. Filosa.

Chapter 11 on retail distribution: Lee Kowarski.

Chapters 12 and 13 on retirement: Members of the NICSA RetirementCommittee: co-chairs Allan Browns and Perri Williams and mem-bers Holly Denton and Sharon Scheid. Also, the retirement specialistteam at OppenheimerFunds.

Chapter 13 on IRAs and annuities: Danielle Holland and FrankO’Connor.

Chapter 14 on fund operations: John Gray and NICSA board membersBrian Jones and Fred Quatrocky.

Chapter 15 on ETFs: Karl-Otto Hartmann.

Chapter 16 on hedge funds: Joseph H. Morgart and Karl-Otto Hart-mann.

Chapters 17 and 18 on cross-border investing and asset gathering:Christopher R. Bohane.

Appendix to Chapter 18 on Chile and Singapore: Lourdes Long.

We thank the following individuals for their fast responses to our ques-tions: Tony D’Elia, Frank Polefrone, Debbie Seidel, Eileen Storz-Salino, ShivTaneja and Mark Trenchard.

Bob thanks his wife Liz for her patience and support. He thanks BobShiller for graciously agreeing to write the Foreword to the book. He alsois grateful to Theresa for taking the lead in doing the substantial revisionsneeded to produce such an excellent second edition.

xvii

xviii ACKNOWLEDGMENTS

Theresa thanks the NICSA staff and the NICSA board for their support.She also thanks her husband, Greg Schumaker, who agrees that the secondedition was a lot easier than the first.

Robert PozenTheresa HamacherOctober 2014

SECTION

OneAn Investor’s Guide to

Mutual Funds

Mutual funds are designed to make life easier for investors. Funds givesavers of even modest means a convenient access to top-quality invest-

ment management at a reasonable price.Since the mission of funds is to serve investors, we start this book by

taking a look at mutual funds from an investor’s perspective. We give anoverview of mutual funds by focusing on five critical questions:

1. Why invest through mutual funds?2. How do mutual funds work?3. How do investors research a potential mutual fund purchase?4. How do investors choose a mutual fund that’s right for them?5. What does it cost to own a mutual fund?

This section has five chapters:

Chapter 1 provides an introduction to investing through mutualfunds. It reviews their advantages and disadvantages, summarizestheir history, and discusses how they are used by investors today.It concludes by providing an overview of the entities that workto ensure that funds meet their obligations to investors: thegovernment regulators and the industry associations.

Chapter 2 describes the basic structure and operations of a mutual fund.It begins with a discussion of two key fund features: daily liquidity at

1

2 THE FUND INDUSTRY

net asset value and pass-through tax status. It explains how fundsoperate through contracts with service providers supervised by aboard of directors, and it discusses the ethical standards that applyto fund managers. Finally, it compares mutual funds to alternativemethods of investing, either directly in securities or through othercommingled investment vehicles.

Chapter 3 explains how investors can learn about potential mutual fundinvestments through information provided by the funds themselves.It begins with a review of the principle of disclosure. It then focuseson the summary prospectus of a mutual fund and continues withan overview of the other parts of the prospectus and of the share-holder reports. It ends with a discussion of how investors can usethis information to select mutual funds.

Chapter 4 discusses how investors might go about choosing a mutualfund. It places funds in the context of a personal financial planand then explains the various approaches to evaluating fundperformance results. It next reviews each type of mutual fund andends with a discussion of the factors investors should considerwhen choosing funds in that category.

Chapter 5 discusses the importance of mutual fund fees and explains thecharges that investors pay when they own a fund. It also reviews thecontroversy regarding those fees, especially the level of the manage-ment fee. Finally, it reviews the arguments in favor of both passive(index) and active investing, a discussion that is very relevant tomutual fund fees because of the differing costs of the two types ofinvesting.

CHAPTER 1Investing through Mutual Funds

The odds are high that you already own a mutual fund. You’re in goodcompany: at the end of 2013, an estimated 96million people in the United

States had, on average, invested 22 percent of their money through a fund.1

Notice that we say that you invest through a mutual fund rather than in afund. That’s because a mutual fund isn’t really an investment itself; it’s justan intermediary—a financial intermediary.

Mutual funds have made it easy for individuals (you, me, and anyonewith money to invest) and institutions (corporations, foundations, pensionfunds) to pool their money to buy stocks, bonds, and other investments.A fund is mutual because all of its returns—from interest, dividends, andcapital gains—and all of its expenses are shared by the fund’s investors.

Funds offer investors advantages over buying and selling securitiesdirectly, including:

■ Reduction of risk by investment diversification.■ Ability to sell your investment daily.■ Access to the expertise of professional money managers.■ Ability to participate in investment strategies that might not otherwisebe available to smaller investors.

■ Administrative convenience and shareholder services.■ A high level of investor safeguards.■ Comprehensive reporting that enables easy comparisons among funds.

These benefits have proven to be very popular with investors around theworld; they held a total of $30 trillion in fund assets at the end of 2013. U.S.households now put more of their money into mutual funds than they dodirectly into stocks, making mutual funds an integral part of financial plan-ning for many people.2 We describe a few typical fund buyers in “MutualFund Investors.”

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4 THE FUND INDUSTRY

MUTUAL FUND INVESTORS

Are you—or is someone you know—like one of these typical mutualfund investors?

■ A middle-aged couple looking to retire sometime in the next 10 to15 years. He works for a technology company, while she runs herown consulting business. They’re building a retirement nest egg byinvesting in stock mutual funds through his company’s 401(k) planand her individual retirement account.

■ A grandmother who wants to help finance the college tuition of hertwo infant granddaughters. She opens college savings accounts forboth, planning to make annual contributions. She puts the assetsin each account into a balanced mutual fund that holds a mix ofstocks and bonds.

■ A young professional tired of paying rent for his small apartmentin the city. He has a goal of moving into his own condo in a fewyears and has started setting money aside for the down paymentthrough automatic deductions from his paycheck. His savings gointo a bond mutual fund recommended by a financial adviser.

This chapter provides an introduction to investing through mutualfunds. It reviews:

■ The advantages and disadvantages of investing through mutual funds.■ Their history and their use by investors today.■ The regulators and industry associations that play a key role in the fundindustry.

ADVANTAGES AND DISADVANTAGES OF MUTUAL FUNDS

Mutual funds have gained such acceptance in household finances becausethey offer many advantages that include:

■ Greater diversification. Through a mutual fund, investors may beable to own more securities than they could if they were acting justfor themselves. Plus, investors can diversify even further by buying

Investing through Mutual Funds 5

more than one fund. In 2013, in the United States alone, there werearound 10,000 funds to choose from with many different investmentprofiles—from bond funds to emerging market funds.3 (See “The ABCsof Risk” to understand how diversification helps investors.)

■ Daily liquidity. Investors in the most common type of mutual fund havethe right to sell their position back to the fund at the end of everybusiness day at a price equal to the value of their share of the fund’sholdings. It’s fast and easy, because there’s no need to find another buyeror negotiate a sale price.

■ Professional management. Funds hire professional investors with a highlevel of expertise to buy and sell securities on their behalf. Because thesemanagers are working on behalf of a large number of investors, theycan afford the top-notch analysts and sophisticated technology that canhelp them identify investments with higher returns.

■ Access to investment opportunities. Individuals whowant to invest over-seas often find it easier to go through a mutual fund. Also, some securi-ties are available only to investors with significant assets. For example,only qualified institutional buyers responsible for at least $100 millionin assets can purchase certain restricted stocks and bonds—a test thatmost mutual funds meet but that very few individuals do.4 But by invest-ing through mutual funds, which usually have minimum investments inthe range of only $5,000 to $10,000, individuals are able to participatein these opportunities.

■ Administrative convenience and shareholder services. Funds makebuying and selling simple, offering shareholders the ability to maketransactions over the phone or through the Internet, often 24 hours aday. Fund owners can also take advantage of a host of other services,such as performance reporting, check writing, automatic purchaseprograms, or access to retirement planning and other educationalmaterials.

■ Investor protections. A system of government regulation ensures thatmutual fund assets are legitimately invested. In the United States, thisincludes oversight by an independent board of directors. As a result,investors in funds have less to fear from Ponzi schemes and other formsof theft.

■ Transparency and comparability. Mutual funds are required to reportto their investors regularly on their holdings and investment strategy, sothat investors have a very good idea of what they’re getting into whenthey invest through a mutual fund. Just as important, funds provide allof this information in a standardized format, which makes it easy tocompare offerings.

6 THE FUND INDUSTRY

THE ABCs OF RISK

Reducing your investment risk is simple—all you have to do is buymore than one investment. This strategy of not putting all your eggs inone basket is technically known as diversification.

To understand why it works, it’s useful to think of securities ashaving two kinds of risk: beta risk and alpha risk. Beta (often referredto by the Greek letter b or 𝛽) is the risk of the market overall. Alpha(Greek a or 𝛼), or idiosyncratic risk, is the ups and downs related toa specific investment. Looking at how they work together in a singlestock, the price of that stock will tend to rise and fall with the stockmarket (beta). At the same time, the fortunes of the particular companyissuing the stock will also have a big impact (alpha). As a general rule,a company’s stock will do better than the market when the companynews is good and worse when it is not.

Diversification reduces overall risk by reducing alpha risk. That’sbecause when you hold a diversified portfolio, good news on one secu-rity might offset bad news on another. Diversified investors don’t haveto worry as much about being wiped out when one investment goessour—when, for example, the buggy whip manufacturer they’ve sunktheir money into goes bankrupt after years of declining sales.

On the other hand, diversification doesn’t help at all with beta risk.A diversified portfolio of U.S. stocks, for example, will still be likely togo down in price when the U.S. stock market is doing poorly.

Truly diversified investors spread their savings not just amongindividual investments but also among markets. Not sure whether theeconomy is getting stronger or weaker? You could decide to buy bothstocks and bonds, since stocks tend to do well in a strong economy,while bonds tend to do well in a weak one. Believe there’s a chancethat the United States is losing its competitive edge? You might spreadyour account among stock markets around the world to increase thechance that you have at least some money invested in the countrythat’s doing well.

While the principle of diversification is simple, implementationcan be more complex. For example, the number of securities neededto eliminate alpha risk can vary. One recent study concludes that, inthe U.S. stock market under normal economic and market conditions,holding 40 to 70 stocks is sufficient for diversification. However,fewer holdings are needed when investing in markets outside theUnited States, and more are required to eliminate alpha risk in timesof market distress.5

Investing through Mutual Funds 7

Mutual funds have disadvantages as well. These include:

■ Fees. Investors pay for all these benefits. In 2013, the average investorpaid 0.71 percent of the value of their fund assets for a year’s worthof basic management services, including investment management andadministration, combined with annual marketing charges known as12b-1 fees.6 Excluded from the 0.71 percent figure are the tradingcommissions that funds are charged when they buy and sell stocks. Alsoexcluded: sales loads—paid by some investors when they purchaseshares of a fund—and program fees for using mutual funds as part ofcertain investment plans, such as wrap programs provided by brokeragefirms or variable annuities offered by insurance companies.

How much shareholders pay to own funds varies widely, depend-ing on the type of fund and the way the fund’s shares are distributedto investors. Annual expenses on a money market fund in a 401(k)plan at work may be only 0.20 percent or 20 basis points. (See “BasisPoints” for a definition of that term.) The fees on a high-quality bondfund bought directly from a fund company may be 55 basis points peryear. But a small investment in an alternatives fund purchased through afinancial adviser could cost 2.25 percent in annual fees plus a one-timesales load of 1.0 percent.7 (For a full explanation of mutual fund fees,see Chapter 5.)

Offsetting some of this cost, annual fees are subtracted from a fund’staxable income, making them effectively tax-deductible. By contrast, aninvestor who owns individual securities can’t deduct investment-relatedexpenses unless they add up to more than 2 percent of the investor’sadjusted gross income for that year, a floor that few investors exceed.

■ No control on timing of gains. Mutual funds don’t allow investors tocontrol the timing of capital gains. Investors who own individual stocksor bonds can choose when to sell a security to recognize a tax gain orloss. If they’re not quite ready to pay taxes on the gain from a stock thathas gone up, they can simply decide to wait—maybe until they can sellanother stock at a loss to offset the gain. Shareholders in U.S. mutualfunds, in contrast, don’t have that option. The manager of the mutualfund decides when to sell the securities the fund holds, and the investorsin the fund are required to pay taxes on the net capital gain that sameyear, even if they haven’t reduced their investment in the fund.

■ Less predictable income. Dividend and interest income are normally lesspredictable in mutual funds, which means that investors who place apriority on steady income might be better off owning individual secu-rities. They can buy bonds and hold them until maturity, knowing thatthey will receive the same interest payment regularly until the bonds are

8 THE FUND INDUSTRY

redeemed. In contrast, because amutual fund buys and sells bonds often,the income it generates will vary, depending on the specific combinationof securities owned on any given date.

■ No customization. One final drawback to mutual funds: they don’tallow for any customization. Instead, everyone in a fund gets exactlythe same deal. Investors who object to owning a particular stock can’tinsist that it be sold out of just their accounts. Large investors can’tget breaks on fees that aren’t available to all large investors. In fact,whenever any fund investors are given special treatment, it often leadsto scandal in the industry.

BASIS POINTS

Mutual fund expenses are often expressed as a percentage of fundassets. Two decimal places are typically required for sufficientprecision—for example, 1.07 percent.

Another way to express expenses is in basis points, often referredto casually as bips or beeps. A basis point is one-hundredth of apercent, so that “107 basis points” is the same as “1.07 percent.”

HISTORY AND GROWTH

The growing recognition of the advantages of mutual funds has led to asignificant change in the way that Americans invest. U.S. households havebeen steadily increasing their positions in mutual funds while reducing theirdirect holdings of individual stocks. Let’s take a look at how mutual fundsevolved to become such a key element in individuals’ financial plans.

Early History

Mutual funds as we know them today are a relatively recent innovation,dating back only to 1924.8 That’s when Boston families first set up open-endmutual funds to manage wealth that had become dispersed as it was passeddown through the generations. These open-end funds were innovativebecause they stood ready to accept new money and honor redemptionrequests from investors on a daily basis.

They were not immediately popular. In fact, during much of theroaring 1920s, closed-end funds—which sold a fixed number of shares

Investing through Mutual Funds 9

and didn’t allow investors to redeem daily—were much more success-ful, in part because they could use borrowed money to boost returns.But while this leverage worked to increase returns in the boom years,it generated large losses in the stock market crash of 1929—alongwith calls for more regulation of what had been a very freewheelingindustry.

The Roosevelt administration responded to those calls by driving thepassage of a series of laws, most notably the Investment Company Actof 1940, which established strict standards for the investment industry.Less-scrupulous fund managers had to adapt to the new rules or goout of business. But open-end funds had already largely adopted thesestandards—which put them in a very strong competitive position. Asevidence of the value of the approach, the very first open-end mutual fund,the Massachusetts Investors Trust, is still around today, as part of the MFSfamily of funds.

Nevertheless, the growth rate of mutual funds was modest from the1940s through the 1970s. Funds invested mainly in stocks over this period,meaning that their fortunes were tied to the ups and downs of the market. Asa result, the industry experienced a small growth spurt during the late 1950sand 1960s, when the economy was strong and stock prices were rising. Butthe mini-boom turned to prolonged bust when stocks plummeted in 1973.In the ensuing recession, it became very difficult, if not impossible, to sellstock mutual funds.

By the end of the decade, with the stock market still moribund, theaction was in interest rates. From 1979 through 1982, interest rates soaredinto double digits, seldom dropping below 10 percent, and at one point ris-ing to almost 20 percent. But most individual investors couldn’t earn thesehigh returns at the bank, because banking regulations—specifically Regu-lation Q—capped the rates that a bank could pay on savings and checkingaccounts to less than 5 percent.9 Fat rates of interest were available onlyon $10,000 Treasury bills and $100,000 certificates of deposit, investmentsbeyond the reach of the average American.

Enter the money market fund. By pooling together money from manyinvestors, money market funds could afford to buy these high-yieldingsecurities, making the attractive returns available to individuals of moderatemeans. The introduction of check-writing privileges made these fundseven more competitive with bank deposits. The public was happy to movemoney out of their low-yield bank savings accounts into the new alternative:between 1977 and 1982, total assets held in money market funds grewfrom less than $4 billion to more than $200 billion. By the end of thatperiod, three-quarters of the mutual fund industry’s assets were in moneymarket funds.

10 THE FUND INDUSTRY

The dominance of money funds was short-lived, lasting only until theearly 1980s. That’s when Regulation Q was phased out, allowing banks tostart paying competitive rates of interest again, and when the nascent bullmarket in stocks and bonds brought other types of mutual funds into thepublic eye. But money market funds remained a key financial tool for bothbusinesses and individuals. And they played a critical role in positioning fundmanagers for the future. They did this by enabling funds to expand theirreach among individual investors, who could exchange easily from moneymarket funds into other types of funds when market conditions were right.

The Surge in Growth

Once investors had been introduced to the advantages of money marketfunds, they were quick to turn to mutual funds for other investment needs.Over a 30-year period ending in 2013, U.S. mutual fund assets increased,from $293 billion to $17.1 trillion. Adjusted for inflation, that’s an annualgrowth rate of 15 percent, significantly higher than the 3 percent per yeargain in real gross domestic product over that same period. (The growthtrajectory is shown in Figure 1.1.)10

The steady expansion in fund assets was primarily the result of threefactors: the bull market in stocks and bonds, new product introductions,and expanded distribution. We take a look here at each.

Growth factor 1: The bull market for both stocks and bonds. Risingprices for stocks and bonds from 1984 to 1999 increased the value of

Bull marketbegins

Internet bubblebursts

Credit crisis

$17,058

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

$18,000

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

$ B

illio

ns

FIGURE 1.1 Growth in U.S. Mutual Fund AssetsSource: Investment Company Institute, 2014 Investment Company Fact Book.