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 MarketICI 2004 – US Household OwnershipICI 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 marketCan 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 performanceInvestors practice “buy high, sell low”

“Capturing benefits” - mutual fund gauntlet

(1) Portfolio performanceEquity funds: average = stock marketCan 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 performanceInvestors practice “buy high, sell low”

“Capturing benefits” - mutual fund gauntlet

(1) Portfolio performanceEquity funds: average = stock marketCan 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 performanceInvestors 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

urns

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 JenkinsWall 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” definitionIDs majorityIndependent legal counselIDs nominate, selectIDs set own payD&O insurance

“Lead” IDNo IA execs

2/3YesYesYesYes

YesWait 5 yrs

75%Yes--

Yes--

Management arrangements

Independent committeeReview processOutside consultant

AuditExecutive mtg

--

ReviewAll info

Yes

Portfolio trading

Seek best execution, MFN fees“Directed brokerage”

----

YesNot permit

Portfolio valuation

Standing committeeStay on top

----

YesYes

Conflicts of interest

Directors own funds overseeSelf-evaluation / ID education

YesQuestionnaire

YesYes

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 dutiesCourts 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 dutiesCourts 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 dutiesCourts 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 dutiesCourts 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 dutiesCourts to “guard the guards” [Juvenal, 160AD]

Professional, certified independent directorsSelf-regulatory organization (like NASD, PCAOB)Minimum standards / disciplinary apparatus