The U.S. Mutual FundThe U.S. Mutual FundIndustryIndustry

Martin J. GruberNomura Professor of FinanceStern School of BusinessNew York University Milan – May 18, 2006

BibliographyBibliographyModern Portfolio Analysis and Investment Analysis, Modern Portfolio Analysis and Investment Analysis, Edwin J. Elton,Edwin J. Elton,Martin J. Gruber, Stephen Brown and William Martin J. Gruber, Stephen Brown and William GoetzmannGoetzmann, John Wiley and Sons,, John Wiley and Sons,Sixth Edition, 2003Sixth Edition, 2003The Performance of Publicly Offered Commodity Funds, The Performance of Publicly Offered Commodity Funds, Edwin J. Elton,Edwin J. Elton,Martin J. Gruber and Joel C. Martin J. Gruber and Joel C. RentzlerRentzler, , Financial Analysts JournalFinancial Analysts Journal, July-August, July-August19901990

New Public Offerings, Information, and Investor Rationality: The CaseNew Public Offerings, Information, and Investor Rationality: The Caseof Publicly Offered Commodity Funds, of Publicly Offered Commodity Funds, Edwin J. Elton, Martin J. Gruber andEdwin J. Elton, Martin J. Gruber andJoel C. Joel C. RentzlerRentzler, , Journal of BusinessJournal of Business, January 1989, January 1989

Professionally Managed Publicly Traded Commodity Funds, Professionally Managed Publicly Traded Commodity Funds, Edwin J.Edwin J.Elton, Martin J. Gruber and Joel C. Elton, Martin J. Gruber and Joel C. RentzlerRentzler, , Journal of BusinessJournal of Business, April 1987, April 1987Efficiency With Costly Information: A Reinterpretation of EvidenceEfficiency With Costly Information: A Reinterpretation of EvidenceFrom Managed Portfolios, From Managed Portfolios, Edwin J. Elton, Martin J. Gruber, Edwin J. Elton, Martin J. Gruber, SanjivSanjiv DasDas and andMatthew Matthew HlavkaHlavka, , The Review of Financial StudiesThe Review of Financial Studies, 1993, 1993

The Performance of Bond Mutual FundsThe Performance of Bond Mutual Funds, Christopher R. Blake, Edwin J., Christopher R. Blake, Edwin J.Elton and Martin J. Gruber, Elton and Martin J. Gruber, Journal of BusinessJournal of Business, July 1993, July 1993

Fundamental Economic Variables, Expected Returns, and Bond FundFundamental Economic Variables, Expected Returns, and Bond FundPerformance, Performance, Edwin J. Elton, Martin J. Gruber and Christopher R. Blake,Edwin J. Elton, Martin J. Gruber and Christopher R. Blake,Journal of FinanceJournal of Finance, September 1995, September 1995

Survivorship Bias and Mutual Fund Performance, Survivorship Bias and Mutual Fund Performance, Edwin J. Elton, Martin J.Edwin J. Elton, Martin J.Gruber and Christopher R. Blake, Gruber and Christopher R. Blake, The Review of Financial StudiesThe Review of Financial Studies, Winter 1996, Winter 1996The Persistence of Risk-adjusted Mutual Fund Performance, The Persistence of Risk-adjusted Mutual Fund Performance, Edwin J.Edwin J.Elton, Martin J. Gruber and Christopher R. Blake, Elton, Martin J. Gruber and Christopher R. Blake, Journal of BusinessJournal of Business, April 1996, April 1996

Another Puzzle: the Growth in Actively Managed Mutual Funds,Another Puzzle: the Growth in Actively Managed Mutual Funds,Martin J. Gruber, Martin J. Gruber, Journal of FinanceJournal of Finance, June 1996, June 1996

Do Investors Care About Sentiment? Do Investors Care About Sentiment? Edwin J. Elton, Martin J. GruberEdwin J. Elton, Martin J. Gruberand Jeff and Jeff BusseBusse, , Journal of BusinessJournal of Business, October 1998, October 1998

Common Factors in Mutual Funds Returns, Common Factors in Mutual Funds Returns, Edwin J. Elton, Martin J.Edwin J. Elton, Martin J.Gruber and Christopher R. Blake, Gruber and Christopher R. Blake, European Finance ReviewEuropean Finance Review, November 1999, November 1999Spiders: Where Are the Bugs?, Spiders: Where Are the Bugs?, Edwin J. Elton, Martin J. Gruber GeorgeEdwin J. Elton, Martin J. Gruber GeorgeComer and Kai Li, Comer and Kai Li, Journal of BusinessJournal of Business, June 2002, June 2002

A First Look at the Accuracy of the CRSP Mutual Fund Database andA First Look at the Accuracy of the CRSP Mutual Fund Database andComparison With Morningstar Data, Comparison With Morningstar Data, Edwin J. Elton, Martin J. Gruber andEdwin J. Elton, Martin J. Gruber andChristopher R. Blake, Christopher R. Blake, Journal of FinanceJournal of Finance, December 2001, December 2001

Incentive Fees and Mutual Funds, Incentive Fees and Mutual Funds, Edwin J. Elton, Martin J. Gruber andEdwin J. Elton, Martin J. Gruber andChristopher R. Blake, Christopher R. Blake, Journal of FinanceJournal of Finance, April 2003, April 2003

Are Investors Rational? Choices Among Index Funds, Are Investors Rational? Choices Among Index Funds, Edwin J. Elton,Edwin J. Elton,Martin J. Gruber and Jeff Martin J. Gruber and Jeff BusseBusse, , Journal of FinanceJournal of Finance, February 2004, February 2004

The Adequacy of Investment Choices Offered by 401K plans,The Adequacy of Investment Choices Offered by 401K plans,forthcoming, forthcoming, The Journal of Publics EconomicsThe Journal of Publics Economics, 2006, 2006

Participant Reaction and the Performance of Funds Offered by 401KParticipant Reaction and the Performance of Funds Offered by 401Kplans, plans, working paper, working paper, Stern School of BusinessStern School of Business, 2006, 2006

Professional CredentialsProfessional Credentials

Consultant on Mutual FundsConsultant on Mutual FundsMember Board of DirectorsMember Board of DirectorsDWSDWSDaiwa Closed End FundsDaiwa Closed End FundsFormerlyFormerly

Member of Board of TIAAMember of Board of TIAAChairman of Board of CREFChairman of Board of CREFMember of Board of SG Cowen FundsMember of Board of SG Cowen Funds

U.S. Mutual Funds by Type (market value)

Fixed Income15%

Money Market23%

Equity61%

Based on 12/05 Assets Total $8.91 Trillion

1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003

0

1000

2000

3000

4000

5000

6000

Bill

ions

of U

.S. D

olla

rs

Growth of Mutual Funds by Type

Bond & Income Money Market Equity

5 year average 2.05% 10.8% 4.8% 4.4%annual growth

79777977519151912015201587187120052005

81268126511051102043204397397320032003

80378037505350532043204394194120042004

82698269524052402040204098998920022002

8307830752015201209120911015101520012001

8246824649424942226222621042104220002000

7808780844974497226622661045104519991999

62936293262626262679267998898819961996

34273427121712171389138982182119911991

1840184070170165465448548519861986

66566530630618018017917919811981

505505294294150150616119781978

TotalTotalEquityEquityBond &Bond &IncomeIncome

MoneyMoneyMarketMarketYearYear

Growth of U.S. Mutual Funds by Type(Market Value)

NUMBER OF MUTUAL FUNDS

161361 426 564

1,528

3,105

3,850

4,558

5,3575,761

6,2936,684

7,343

7,808

8,246 8,3078,037 7,977

8,269 8,126

0

1000

2000

3000

4000

5000

6000

7000

8000

1960 1970 1975 1980 1985 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

79777977519151912015201587187120052005

81268126511051102043204397397320032003

80378037505350532043204394194120042004

82698269524052402040204098998920022002

8307830752015201209120911015101520012001

8246824649424942226222621042104220002000

7808780844974497226622661045104519991999

62936293262626262679267998898819961996

34273427121712171389138982182119911991

1840184070170165465448548519861986

66566530630618018017917919811981

505505294294150150616119781978

TotalTotalEquityEquityBond &Bond &IncomeIncome

MoneyMoneyMarketMarketYearYear

Growth of U.S. Mutual Funds by Type(Number of Funds)

Number of Mutual FundNumber of Mutual FundComplexesComplexes

Over 400 in 2004Over 400 in 2004Top Ten Companies Hold 56% ofTop Ten Companies Hold 56% ofAssetsAssetsTop 25 Complexes 76% of AssetsTop 25 Complexes 76% of Assets

Percent of U.S. Households Owning Mutual Funds

6%

11% 12%

20%

24% 25%27%

31%

37% 37%

44%47%

49%52%

50%48% 48% 48%

0%

10%

20%

30%

40%

50%

60%

1980 1982 1984 1986 1988 1990 1992 1994 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

• 54 million households owned mutual funds

• 35.6 million households owned within employee sponsored plans

• 38.9 million households owned outside employee sponsored plans

Channels Used for Mutual Fund Investments (Percent of Respondants)

0%

5%

10%

15%

20%

25%

30%

35%

40%

Full ServiceBroker

Discount Broker Insurance Agent BankRepresentative

Financial Planner Direct Marketer

35.2% 13.3% 4.7% 9.4% 17.8% 19.6%

*1/3 Online*1/3 Online 2/3 Office2/3 Office

2.132.13

2.202.20

2.182.18

TotalTotalLoadLoad

0.370.371.101.1042184218All bondsAll bonds

0.410.411.511.5193119311All EquitiesAll Equities

0.400.401.371.371352913529All FundsAll Funds

12B-112B-1FeesFees

ExpenseExpenseRatioRatio# Funds# Funds

0.370.372.132.131.251.25995995Growth and IncomeGrowth and Income

0.420.422.312.311.361.36246246Equity IncomeEquity Income

0.370.371.951.951.531.53910910Small CompanySmall Company

2.322.32

2.232.23

2.282.28

TotalTotalLoadLoad

0.430.431.811.8117581758International StockInternational Stock

0.410.411.431.4331243124GrowthGrowth

0.430.431.651.65245245Aggressive GrowthAggressive Growth

12B-112B-1FeesFees

ExpenseExpenseRatioRatio# Funds# Funds

0.080.080.000.000.750.7516461646 No Load No Load

0.240.243.893.890.970.9712521252 Front Load Front Load

0.320.324.794.791.471.4723852385 Front Load Front Load

0.930.933.273.272.112.1129312931 Deferred Load Deferred Load

All BondsAll Bonds

3.023.02

0.000.00

Total LoadTotal Load

0.840.841.621.6214391439 Deferred Load Deferred Load

0.120.121.151.1542144214 No Load No Load

All EquitiesAll Equities

12B-112B-1FeesFeesExpense RatioExpense Ratio# Funds# Funds

19.919.91,396,1311,396,131390,673390,673LuxembourgLuxembourg

10.010.0492,726492,726253,683253,683United KingdomUnited Kingdom

16.116.18,045,5568,045,5562,822,7962,822,796Total Non-USATotal Non-USA

3.63.6399,462399,462311,335311,335JapanJapan

54.154.1467,620467,62022,72822,728IrelandIreland

13.613.6511,733511,733209,410209,410ItalyItaly

15.615.61,370,9541,370,954495,774495,774FranceFrance

10.510.5295,997295,997146,888146,888GermanyGermany

8.98.9

11.111.1

50.050.0

Annual %Annual %GrowthGrowth

8,106,8738,106,8734,468,2014,468,201U.S.U.S.

413,772413,772197,985197,985CanadaCanada

653,073653,07342,90942,909AustraliaAustralia

2004200419971997

Only Countries with assets over 2 m in 2004 included in the listTotal Non-USA includes 39 countries for which ICI collect data

Worldwide Assets of Open-end Investment Companies(millions of U.S. dollars)

The Retirement MarketThe Retirement Marketand How it Investsand How it Invests

Total Retirement MarketTotal Retirement Market(2004)(2004)

12.9 Trillion Dollars12.9 Trillion Dollars3.1 T or 24% in Mutual Funds3.1 T or 24% in Mutual Funds9.8 or 70% Managed by Pension9.8 or 70% Managed by PensionFunds, Banks, Insurance Companies,Funds, Banks, Insurance Companies,and Brokerage Firmsand Brokerage Firms

Retirement Market (2004)Retirement Market (2004)

24%3.1TGovernment Plans

9%1.2 TFixed and Variable Annuity

27%3.5 T24%43%IRA’s

14%1.8 T1%Private Defined Benefit Plan

25%3.2 T9%50%Defined Contribution Plan Primarily 401 (k)Plans (68% of Total)

% ofRM

Size inTrillion

Sharein

1990

SharesInvested In

MutualFunds

Its Importance to theIts Importance to theMutual Fund IndustryMutual Fund Industry

How Important is the RetirementHow Important is the RetirementMarket to Mutual Funds?Market to Mutual Funds?

1990: 19% Owned by Retirement1990: 19% Owned by RetirementAccountsAccounts2004: 38% Owned by Retirement2004: 38% Owned by RetirementAccountsAccounts2004: 50% of Long Term Funds2004: 50% of Long Term Funds

Growth Rate of Retirement Plan Assets inGrowth Rate of Retirement Plan Assets inMutual Funds (Assets in billions of dollars)Mutual Funds (Assets in billions of dollars)

12.818644Other – PrivateRetirementPlans

12.229474403(b) Plans

24.0108682401(k) Plans

16.51487237IRAs

Growth Rate PerYearAssets in 2004Assets in 1992

Type ofRetirement Plan

How Are Retirement Assets InvestedHow Are Retirement Assets InvestedBy Retirement Market (2004)By Retirement Market (2004)

Common Stock – DomesticCommon Stock – Domestic 60%60%Common Stock – ForeignCommon Stock – Foreign 10%10%BondsBonds 10%10%Money Market FundsMoney Market Funds 8%8%Hybrid FundsHybrid Funds 12%12%

How Plans Allocate Their MutualHow Plans Allocate Their MutualFund Investments (2004)Fund Investments (2004)

8.2%

9.7%

4.4%

6.9%

9.7%

MoneyMarket

$3,053

4186

$294

$1,086

$1,487

TotalDollars

(billions)

11.3%11.8%

8.6%59.1%Other – PrivateRetirement Plans

11.8%10.2%

9.8%60.1%Total

7.5%

13.1%

11.8%

Hybrid

6.1%

8.7%

11.8%

Bond

7.5%74.3%403(b) Plans

10.5%60.9%401(k) Plans

9.9%56.8%IRAs

ForeignEquityDomestic

Type of RetirementPlan

Customer Services – includingCustomer Services – includingrecord keeping, the ability to moverecord keeping, the ability to movemoney around among funds, andmoney around among funds, anddaily valuationdaily valuation

Low Transaction CostsLow Transaction Costs

Low Cost DiversificationLow Cost Diversification

Professional ManagementProfessional Management(security diversification)(security diversification)

Open end mutual funds sell at the net assetvalue.

If “good management” exists, a fundwhich has superior management will sell atnet asset vale. If “bad management” exists, afund which has inferior management willsell at net asset value.

Management is not priced Management is not priced.

Counter argument.

Average PerformanceAverage Performance

0.0950.095

0.0900.090

ßßBB

0.2900.290

0.2290.229

ßßGG

0.8010.8010.3910.3910.7810.781-2.748-2.748Non-Non-survivingsurviving

0.8860.8860.3140.3140.8500.850-0.648-0.648OpenOpenEndEnd

??22ßßSSßßMMaa

Ranked By Previous 1-Year AlphaRanked By Previous 1-Year Alpha

3.4083.408**Top – BottomTop – Bottom0.8910.891* ** *Spearman RankSpearman Rank 0.816 0.816Top 10Top 10-0.156-0.15699 0.060 0.06088 0.528 0.52877-0.468-0.46866-0.240-0.24055-0.528-0.52844-0.444-0.44433-1.080-1.08022-2.592-2.592Bottom 1Bottom 1

1 year alpha1 year alphaDecileDecile

* Significant at 1% level** Significant at 5% level

Ranked By Previous Expense RatioRanked By Previous Expense Ratio

1.6201.620**Low – HighLow – High0.5520.552Spearman RankSpearman Rank-0.096-0.096LowLow-0.216-0.216990.1560.156880.5640.564770.1200.12066-0.024-0.02455-0.012-0.01244-0.828-0.82833-0.948-0.94822-1.716-1.716HighHigh

1 year alpha1 year alphaDecileDecile

* Significant at 1% level

Realized Annual Three Year Four IndexRealized Annual Three Year Four IndexAlpha Predicted By Expense RatioAlpha Predicted By Expense Ratio

1.6201.620**Low – HighLow – High0.5520.552Spearman RankSpearman Rank-0.096-0.096LowLow-0.216-0.216990.1560.156880.5640.564770.1200.12066-0.024-0.02455-0.012-0.01244-0.828-0.82833-0.948-0.94822-1.716-1.716HighHigh

Exp RatioExp Ratio††DecileDecile

† Expense ratios are reported from high to low* Significant at 1% level

Expense Ratios for Deciles FormedExpense Ratios for Deciles Formedon the Basis of Four Index Alphas:on the Basis of Four Index Alphas:

1.0631.063

1.0481.0481.0371.0371.0531.0530.9980.9980.9700.9701.0291.0290.9840.9841.0311.0311.0681.0681.4131.413t+2t+2

1.0781.078

1.0581.0581.0551.0551.0801.0801.0071.0070.9670.9671.0491.049.0998.09981.0641.0641.0841.0841.4151.415t+3t+3

1.0391.039

1.0421.0421.0271.0271.0351.0350.9730.9730.9550.9550.9710.9710.9600.9601.0181.0181.0501.0501.3571.357

tt

1.0891.0891.0491.049MeanMean

1.0571.0571.0521.05210101.0281.0281.0431.043991.1191.1191.0161.016881.0501.0500.9860.986770.9590.9590.9620.962661.0641.0640.9940.994551.0241.0240.9680.968441.1151.1151.0071.007331.0721.0721.0611.061221.4001.4001.4051.40511t+4t+4t+1t+1DecileDecile (t) (t)

Annual Cash Flows for Deciles FormedAnnual Cash Flows for Deciles Formedon the Basis of Four Index Alphas inon the Basis of Four Index Alphas in

the Year Following Formationthe Year Following Formation

1.6201.620**Top – BottomTop – Bottom1.001.00**Spearman RankSpearman Rank29.029.0101012.812.8996.66.6884.54.577-2.4-2.466-3.7-3.755-5.0-5.044-5.1-5.133-11.2-11.222-15.4-15.411

% Change in Cash% Change in CashFlowFlowDecileDecile

* Significantat 1% level

Annual Realized Cash Flow WeightedAnnual Realized Cash Flow WeightedAlphaAlpha

0.06600.0660

0.09840.0984

0.03960.0396

3 Years3 Years

0.26520.2652

0.22440.2244

0.28920.2892

1Year1Year

0.52800.5280

0.85440.8544

0.35160.3516

1Quarter1Quarter

Holding PeriodHolding Period

NegativeNegative

Weighted Avg.Weighted Avg.

PositivePositive

Return on CashReturn on CashFlowsFlows

Buy at End of Quarter

• Index funds outperform actively managed fundsof the same riskActive funds 65b.p. below indexes.Charge fee of 130 b.p.Bring information worth 65b.p. but charge130b.p.

• Funds that charge higher fees tend to do worsethat funds that charge lower fees

• Funds that perform well have a slight tendency tocontinue to perform wellFunds that perform really badly tend to continueto perform really badly

• Investors seem to be aware of this.Funds that perform well have higher subsequentcash flows.Funds that perform badly have high cash outflows.

• The result of this is that new investment anddisinvestment earns a risk adjusted return slightlyabove that which would be earned on a set ofindex funds with the same risk.

• A sophisticated clientele.

• A disadvantaged clientele.

• Unsophisticated investors

• Institutionally disadvantaged investors

• Tax disadvantaged investors