Mutual Funds
Still the Best Way to Invest!
By Richard P. Halverson

It seems like nothing is too good for a scandal these days.  One of the recent scandals surrounds the mutual fund industry.  The problem making headlines involved a few large institutional investors being granted special information and trading privileges in a handful of funds.  Some of the activity was preferential to large clients versus small investors and some of the activity appears to have been illegal. The incidents will likely prove to be isolated. This article is not about these problems. However, I am sure some investors are now wondering if they should put their money in mutual funds.  The answer is the mutual fund industry has its warts BUT the concept is still by far the best investment vehicle ever invented for most people who do not have the time, inclination or financial resources to be professional investors.  It is a good time to review what mutual funds are and how you can use them.

UNDERSTANDING MUTUAL FUNDS

A MUTUAL FUND IS A CORPORATION

A mutual fund is a non-operating corporation.  Many investors come together to pool their resources.  This allows each shareholder to participate in an investment strategy in a way they could not on their own.  The shares investors buy are registered securities.  The distribution of the shares and the management of the fund are heavily regulated by the SEC.

There are two types of funds, open-end and closed-end funds.  Open-end funds sell and redeem shares directly in the fund every day.  Proceeds of a new investment go into the fund to be invested. Closed-end funds do not sell new shares directly to the public.  An investor buying shares will buy from an existing shareholder.  Proceeds from a new investment go to the previous shareholder.  My comments here pertain primarily to open-end funds.

THE CORPORATE BOARD

As a legal corporation the fund has a board of directors elected by the shareholders.  Their responsibility is to hire professionals to manage all aspects of the fund.  The board also has a fiduciary responsibility to represent the shareholders and see that their best interests are served.

THE MANAGEMENT COMPANY

The board is responsible to hire a qualified professional to make and implement the investment decisions for the fund.  Generally, this is an investment management company not an individual.  The portfolio manager works for the investment management company.

There are many other needs that the fund has such as accounting and reporting.  The board also hires professionals to perform these tasks on behalf of the fund.  Normally, it is the same management company.

The management company receives fees for their services.  These fees are paid out of the assets of the fund. 

THAT’S THE THEORY

In theory fund shareholders come together and pool their assets.  They elect a board that looks out for their best interests in all things.  The board hires the best professionals available.  Everyone is independent, professional and focused on doing well for the shareholder.  That’s the theory!

In reality it works almost the opposite.  The investment management company wants to make more money by having more assets to manage.  They determine that a mutual fund will be attractive to investors.  So, in practice, rather than an independent board hiring the best management company to run the fund, it is the management company looking around to find someone to invest in the fund they have dreamed up.

The management company spends its own dollars to get the fund registered with the SEC.  This is an expensive and difficult process and no group of friends and neighbors are ever going to get together to do it.  So, most funds wouldn’t exist if it weren’t for the incentive the management companies have.

The management company selects and nominates the board to the shareholders.  This board will consist almost entirely of employees and close friends of the management company.  Remember, in theory, this board is supposed to be independent and is supposed to be hiring the management company.  In reality mutual fund boards are not truly independent, even when the majority of members are not employees of the management company.

I must note that these funds are heavily regulated and the legal fiduciary responsibilities that board members assume are for real.  This does provide a powerful check on the board. Thus it is fair to assume the board will not knowingly allow the management company to engage in truly egregious activities.  But you should know that within limits the board will be sympathetic to the management company when it comes to establishing all kinds of policies and fees.  Fees that are paid by your fund assets.

STILL THE BEST GAME IN TOWN

The mutual fund industry has its warts.  The boards are not as independent as they should be.  This means they may authorize fees that are higher than necessary.  They may tolerate poor investment performance longer than they should.  They will almost never fire the management company for cause or any other reason.  In the end for all practical purposes funds are “owned” by their management companies rather than by the fund’s shareholders.  The fund is created by the company, it usually carries the name of the company, its investment objectives and practices are all determined by the company, the fund is distributed, managed, and serviced by the company, and the board is generally very closely aligned with the company.  This is not a prescription for putting the fund shareholders interests ahead of the management company’s interests.

Still, I am a great fan of mutual funds and I strongly recommend their use.  The concept of small investors being able to pool their assets for diversification, professional management and other investment services is very sound.  There is substantial regulation and competitive checks and balances to prevent the management companies from plundering the assets.  I believe a practical understanding of real world problems is not a reason to ignore the industry.  Rather such an understanding helps in making better fund selection decisions.

BUYING IDEAS

KNOW YOUR OBJECTIVES

The first key in buying the right mutual fund (or making any other investment) is to know what your investment objectives are.  You need to make decisions about what you are saving for, what your time horizon is and what your risk tolerance is.  This is a big subject.  I have written several Meridian articles related to it and will not spend any time with it here.

DECIDE WHERE YOU WANT TO BUY YOUR FUNDS

There are three ways most people use to buy mutual funds.

First, is to work with a stockbroker or commission based financial planner.  Some of these professionals work exclusively for a particular management company. When you select someone being paid a commission you should expect to get considerable help in selecting the correct fund for you.  This should include help in setting your personal financial goals and selecting the funds that best meet them.

You should also expect to pay for the services they offer. The fees can be substantial.  You will also find that these people deal only with a limited number of funds.  If you go to a stockbroker they can theoretically sell you almost any fund.  In practical terms all stockbrokers have a limited number of funds they like to use and recommend.  They can’t keep track of 8,000 funds any more than anyone else. Commission based financial planners may work exclusively for a particular company or their firm may have a marketing relationship with a few companies.

Second, you can choose to buy funds from one of the many management companies that do not distribute their funds through commissioned professionals.  You must contact the management company directly to make your purchase.  These funds have no up-front marketing fees and are referred to as “no-load” funds.  They are substantially less expensive to purchase.  However, you must do all your own research.

Finally, employer sponsored retirement and savings plans are a huge source of investment into mutual funds.  This channel generally offers a limited number of choices and is restricted to the ones the employer has selected.  Normally, as an employee you can have confidence that the employer is trying to offer high quality choices.  However, in making the selection the employer will consider various services and fees that are important to the employer but not necessarily to the employee.  This channel is generally low cost to the investor.  Usually it has no loads or marketing fees to the employees and often the employer pays for some of the other fees.

RESEARCHING MUTUAL FUNDS

Read the prospectus.  I know prospectuses are boring, filled with bafflegab and investment legalese. (I hate them and I used to write them.)  Nor will you feel as uplifted by reading a prospectus as you will by reading the scriptures.  But the prospectus has important information.  And by law no one can sell you a fund without offering you a prospectus.  There are good reasons why these laws are on the books.

Pay attention to these areas:

You can obtain a prospectus from anyone who is trying to sell you a fund.  Or you can go to the management company’s web-site.

Independent research firms. The best known sources for independent mutual fund research are Morningstar [www.morningstar.com] and Lipper [http://www.lipperweb.com].  Both of these companies provide a lot of useful information free.  Their complete services require a subscription.  Here you can compare investment performance and fees against industry norms. 

The company web-site.  These sites are useful sources of information.  They all offer information about their funds.  This will include investment objectives, past performance, fees, management profiles etc.  You can also see what other services the company offers such as on-line account information, investment calculators, information regarding IRA’s, quicken downloads, etc.  Of course, you can also get a prospectus at the site.  Incidentally, while the companies understandably try to put their best foot forward the SEC strictly regulates advertising.  Consequently, you can have a little more confidence about what you learn here as compared to what you might learn on a car manufactures site.

ALL THINGS BEING EQUAL CHOOSE THE FUND WITH THE LOWEST FEES

Note, I did not say make fees your only, or even your primary, consideration.  But all things being equal choose low fees.

Marketing fees.  If you use a broker or a commissioned financial planner they deserve to be paid.  They are compensated out of these marketing fees.  Many funds charge a front-end load.  For example, a front-end load of 5.25% is typical.  An individual investing $10,000 will find that the fund’s quoted value immediately drops to $9,475. (That’s worse than driving a new car off the lot.) The difference goes to pay the broker and other marketing costs.  (Incidentally, this means the fund must appreciate 5.54% just to get even.)

12b-1 fees.  These are also marketing fees.  Rather than being charged on the front end they are charged as a percent of the assets in the fund over time.  These fees may be used for on-going advertising and marketing as well as compensation to the selling broker.  These are costs the fund must incur to make you aware of the fund and convince you to invest in it.

Investment management fees.  This fee pays for the actual investment management of the fund.  Certain classes of funds tend to charge higher fees than others.  For example, stock funds tend to charge higher management fees than fixed income funds.  Index funds tend to charge lower fees than actively managed funds.

Administrative fees.  These fees cover costs like record keeping, regulatory filings, prospectuses, auditing fees, board costs, etc.

You will find that these fees differ among funds even with similar investment characteristics. I am not aware of a comprehensive study of fees versus shareholder benefit.  In this day and age when just about everything has been studied it makes sense that such a study exists somewhere.  If it does I would personally be surprised if it demonstrates conclusively that higher fees are associated with higher performance or better investor services.  One thing we do know as a mathematical certainty is that higher fees reduce investment returns. Further, with the effects of compounding the impact of reduced returns due to higher fees becomes more substantial over time.  So, know the fees.  If the fund you are interested in charges high fees be certain you are comfortable you are getting something valuable in return.  All things being equal choose lower fees.

SORTING THROUGH THE JUNGLE

One of the most daunting problems facing the mutual fund investor is the large number of possibilities. According to Forbes Magazine of August 28, 2003 there are over 8,300 mutual funds.  This is more than the number of publicly traded equities.  That is probably a lot more funds than the investing public needs. There are funds of almost every conceivable specialty and description.  And if it doesn’t exist today it probably will tomorrow.  Here are some thoughts that can help you winnow down the field.

Investigate the management company.  How long have they been in business?  Do they offer a full line of products?  Have they consistently had funds producing respectable results?  Do they offer a complete line of investor services?  Do an Internet search on the company for news beyond their own releases.

Avoid specialty funds.  The vast majority of investors are looking for good quality funds that grow or produce income etc.  Advanced investors may be interested in funds that have very narrow investment policies such as investing only in emerging medical device companies.  Unless you consider yourself an expert investor stick to main line funds.

Especially avoid newly introduced specialty funds designed to capture the most recent investment fad.  Management companies are always looking around for funds that will sell.  Too often that has meant introducing a fund just as that particular investment fad was collapsing.  All you must do is look at all the Internet Funds that were introduced in 1999 to understand this phenomenon.

PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE

The most difficult temptation to avoid is buying the fund that was last quarter or last year’s top performing fund.  Study after study has all shown that last year’s hottest fund is very unlikely to be next year’s hottest fund.  (Frequently, next year’s bomb.) Here is a statement I would like to emphasize.

ABSOLUTELY NOTHING HAS EVER BEEN INVENTED THAT CAN ACCURATELY PREDICT WHICH FUND WILL BE THE BEST PERFORMING FUND NEXT YEAR!

Do not frustrate yourself with the idea that there is someway to pick next year’s big winner – there isn’t. 

While past performance is not able to predict future performance history is about all we have to go on. Here are some things to look for that may improve your odds.

Hopefully, what this will lead you to is a fund that is well and consistently run.  Hopefully, what this will help you avoid is a fund that is showing very high past returns because of a very big but isolated period.  And hopefully, this will lead you to a fund that will meet your objectives over time.

The mutual fund industry has its shortcomings.  Most of these shortcomings are not as serious as the recent scandals might suggest.  It is safe and wise to buy mutual funds.  The mutual fund concept is the best mechanism available to the broad cross section of investors.  Through mutual funds many ordinary people have been able to directly participate in the economic growth of this country.