Chapter 9

A HISTORY AND OVERVIEW OF THE MUTUAL FUND BUSINESS

Eighty-five years ago, the first modern mutual fund was born. In March of 1924, the Massachusetts Investors a Trust was launched, beginningis with $50,000 in assets invested in a 45-stock portfolio. That fund is still around today, managed by Massachusetts Financial Services (MFS). According to published data, a hypothetical $1,000 investment made on March 21, 1924, would have been worth approximately $1,000,000 on November 30, 2008 (dividends and capital gains reinvested at net asset value, or NAV). This represents an average annual compounded growth rate of slightly more than 8 percent.

Coming only five years later, the crash of 1929 and the ensuing Great Depression of the 1930s offered a less-than-hospitable climate for the growth of this fledgling industry. Even in this climate, however, the early growth of the fund industry was impressive. By 1940, instead of one fund there were nearly 70. Furthermore, from a total asset base of $50,000, the collective assets of the industry had grown 9,000-fold, to approximately $450 million. This period also witnessed the enactment of a series of laws for the regulation of the securities industry as a whole, forming the basic framework for the operation of the mutual fund industry as it exists today.

Even before the creation of the Massachusetts Investors Trust, there were investment vehicles that can fairly be considered as ancestors of modern mutual funds. Though not as old as stocks and bonds, these diversified investment companies have been around for a lot longer than most people realize. What is now an enormous, multitrillion-dollar industry can trace its ancestry to The Foreign and Colonial Government Trust. This British investment company, created in 1868, possessed one of the key characteristics of a mutual fund: It allowed an individual investor to spread investment capital over many different securities and without needing vast sums of capital.

In the post-World War II period, the fund industry continued to grow, but at a slower rate. Rapid growth resumed with the deregulation of the brokerage business that began on May 1, 1975. A further impetus to growth stemmed from the inflation problems of the 1970s, as individuals withdrew their money from low-interest-paying bank accounts, and moved them into higher-interest-bearing money market funds. With the end of inflation and the birth of the bull market in the 1980s, investors began a major shift from short-term money market funds into equity and bond funds. All told, in the last 70 years or so, the industry has again recorded a 100-fold increase in the number of funds, and a 20,000-fold increase in total capital. Table 9-1 shows the growth of mutual fund assets under management, number of mutual fund shareholder accounts, and total number of funds from 1940- 2008. Table 9-2 shows number of shareholder accounts by investment classification, for the years 1984-2007.

Table 9-1 U.S. Mutual Fund Industry Total Net Assets, Number of Funds, and Number of Shareholder Accounts (end of year)

Source: Investment Company Institute Note: Data for funds that invest primarily in other mutual funds were excluded from the series. *Number of shareholder accounts includes a mix of individual and omnibus accounts.

Table 9-2 U.S. Mutual Fund Industry Number of Shareholder Acounts* by Investment Classification (thousands, end of year)

Source: Investment Company Institute

Note: Data for funds that invest primarily in other mutual funds were excluded from the series.

* Number of shareholder accounts includes a mix of individual and omnibus accounts.

Acts of the SEC

The Securities and Exchange Commission (SEC) is an agency of the federal government. It was created by Congress as part of the Securities Exchange Act of 1934. Its initial purpose was to administer that law, as well as the Securities Act of 1933, which had been enforced by the Federal Trade Commission (FTC). These laws, passed at the height of the Great Depression, were intended to prevent the kind of abuses that had existed prior to the crash of 1929 and to help restore public confidence in the financial markets. Over the next 10 years, the SEC helped draft legislation that in large measure still governs the way securities markets operate in the United States.

IRA

Individual retirement account.

Despite impressive growth, the mutual fund industry has been relatively stagnant over the last decade. Partly, this is a natural result of a maturing industry. Partly, it is a side-effect of the secular bear market. And partly, it is a result of a major new source of competition: exchange traded funds (ETFs).

401(k)

The most popular type of defined contribution pension plan.

Open-End versus Closed-End Funds

The first investment funds offered to the public in the nineteenth century were sold by brokers and traded like ordinary stocks. This type of fund is today known as a closed-end fund. In contrast, most mutual funds in the United States are, like the Massachusetts Investors Trust, of the open-end variety. According to the Investment Company Institute (ICI), there are in 1998 approximately 8,000 open-end funds in the United States.

You may have seen a much higher estimate of the number of U.S. mutual funds. The reason? Many funds are offered with more than one class of shares. If all the separate classes of funds are counted, the total skyrockets to 22,000. It should be noted, however, that these are not really different portfolios, only different ways of packaging funds for marketing purposes. For example, one class of fund might carry an up-front sales charge, while another might have no initial charge, but a contingent (deferred) sales charge (i.e., a charge on sale of the fund that varies depending on how long you hold it).

In contrast, there are only 650 funds of the closed-end variety. Open-end funds tend to be larger as well. Total assets of the 8,000 funds are approximately $9 trillion, or an average of more than $1 billion per fund. In contrast, the total net asset value of U.S. closed-end funds is approximately $240 billion, and the average closed-end fund has only about one-third of the assets, or about $350 million.

The major difference between open- and closed-end funds is how shares are created and priced. With closed-end funds, the number of shares is fixed, resulting in market-related supply/demand forces that determine the price at any given time. Closed-end funds can therefore trade at a discount or a premium to the NAV. Often, funds that provide investors with a way to participate in a hot market are priced at a premium to NAV, whereas most closed-end funds trade at a modest discount. When the discount becomes significant, there is sometimes an effort on the part of the shareholders of the fund to convert it into an open-end mutual fund, an effort that can lead to a battle for control of the fund company.

In contrast, with open-end funds, buyers are issued new shares, while sellers’ shares are “absorbed” by the fund company. Pricing is determined through calculation of the net asset value (see “Calculation of a Net Asset value for the Savvy Fund Investor”), a daily exercise that values individual shares by calculating the underlying assets of the fund, subtracting its liabilities, and dividing by the number of shares outstanding.

Index Funds

Index funds are funds that are designed to replicate an index. They are passively managed portfolios whose objective is to accurately track an index of stocks (or bonds) as closely as possible, at minimal cost. This distinguishes them from the larger universe of actively managed mutual fund portfolios. The securities in actively managed funds are chosen by portfolio managers in accordance with some investment analysis or strategy, and they are supposed to reflect the fund’s objectives, such as current income and/or long-term capital appreciation.

Calculation of a Net Asset Value for the Savvy Fund Investor

How does a fund calculate its net asset value (NAV)? The calculation requires three inputs, as follows:

• Total fund assets

• Total fund liabilities

• Number of shares outstanding

NAVs for many funds are printed in the newspaper every day. To get the NAV of a smaller fund, you may need to go online to a web site that carries fund information (e.g., www.nasdaq.com).

Load versus No-Load Funds

Some open-end funds are sold through brokers. These funds have sales charges and are known as load funds. The load, or sales charge, is set by the distributor of the fund and may depend on the dollar amount of shares purchased, prior share purchases, and the class of the share.

Frequently, load funds are offered with several different pricing structures. Technically, they are all separate funds, even though they are managed together. What distinguishes them is how and when investors are assessed the sales charge. One class of shares is typically priced with front-end load, while another class carries a back-end or deferred sales charge, which is waived if the investor stays in the fund for a minimum period, typically five years. Thus, investors who plan on staying with a fund for five or more years can avoid paying a sales charge by purchasing the back-end or contingent load version of the fund.

Opening a Closed-End Fund: A Double-Edged Sword for Unwary Investors

Frequently, closed-end funds trade at a discount to NAV. This has created an incentive for short-term investors—hedge funds, for example—to take a large position in a closed-end fund and then to attempt to convert it to an open-end fund.

 

Since open-end funds are priced at NAV, this can be a profitable strategy. There is no guarantee, however, that all investors will benefit from the conversion. In particular, long-term investors may find that expenses have increased, NAV has declined, and the need to raise cash to pay exiting investors has forced the fund to realize capital gains, thus presenting the remaining investors with a large tax bill. If you are in a closed-end fund, and there is an effort under way to convert it, you may find that you are better off selling before the conversion is completed.