The following facts about mutual funds illustrate their importance to investors:
l Approximately 52 million U.S. households own mutual funds.
l More than two infive households in the United States own mutual funds.
l In 1990, mutual funds comprised roughly 7 percent of the totalfinancial assets held by households. By 1996, this had grown to 13 percent; by the beginning of 2012, it was about 23 percent.
l Mutual funds owned approximately 29 percent of U.S. stocks at the end of 2011, and since they are simply intermediaries between households and equities, this represents a significant household investment in equities.
l One-third of U.S. households hold mutual funds in employer-sponsored retirement plans.
l The 401(k) plan is a popular type of defined-contribution (DC) plan, and mutual funds managed more than half of the assets in 401(k) and DC plans in 2011.
l Mutual funds managed about 45 percent of the total assets in IRAs in 2011.
Clearly, the fact that so many people have chosen to invest using mutual funds, documents their overall importance when it comes to indirect investing.
The potential benefits of mutual funds to investors are illustrated in Figure 3-2.
Diversification may be the most important reason for buying a typical mutual fund. As we will see in Chapter 7, diversification of your portfolio is the one rule of portfolio man- agement. Many investors cannot build a diversified portfolio on their own because of the amount of money involved to do so. Most mutual funds provide instant diversification.
Mutual funds provide professional managers to handle the portfolios. It seems logical that they should be able to do a good job since that is their full time focus. Whether in fact active managers perform all that well will be considered later.
Convenience refers to the fact that the investor does not have to do the analysis and work involved in managing the portfolio. The investor is, in effect, hiring someone to do this, thereby saving the investor a lot of time and effort.
Mutual funds provide a number of services, including in some cases check-writing on the account, record keeping, preparing information for tax purposes, wiring money as directed by the investor, serving as thefiduciary for retirement accounts, and so forth. They strive to serve their shareholders.
The cost involved can span a range, but in general buying a mutual funds with no sales charge, and paying a low annual expense fee for having the fund managed, is cost-effective.
Defining a Mutual Fund Technically, a mutual fund is an open-end investment company, the most familiar type of investment company. Unlike closed-end funds and ETFs, mutual funds do not trade on stock exchanges. Investors buy mutual funds shares from investment companies, and sell their shares back to the companies.
3 The number of shares outstanding of an open-end investment company (mutual fund) is continually changing—that is, it is open-ended—as new investors buy additional shares from the company and some existing shareholders cash in by selling their shares back to the company. Thus, the fund’s capitalization is said to be open-ended.
Multiple Funds Managed by One Company Individual investment companies are often referred to as“fund complexes” or“fund families” because one company manages multiple funds. Well-known fund families (complexes) include Fidelity, Vanguard, T. Rowe Price, American Funds, Janus, and Dreyfus. At the beginning of 2012, the top 10 complexes controlled 53 percent of industry assets, while the largest 25 fund complexes controlled three- fourths of fund assets. There were approximately 600 fund complexes.
Given the economies of scale in managing portfolios, expenses rise as assets under management increase, but revenues rise more quickly. Investment companies seek to increase the size of the fund(s) being managed as well as operate several different funds simultaneously.
The name of the game in the investment company industry is to get more assets under management. Why?
Figure 3-2 Possible Benefits to Investors of Owning a
Mutual Fund. Diversification
Professional Management
Convenience Services
Provided Cost
Open-End Investment Company An investment company whose capitalization constantly changes as new shares are sold and outstanding shares are redeemed
Example 3-3
As stated in its prospectus (which is designed to describe a particular fund’s objectives, pol- icies, operations, and fees), “Equity-Income is a mutual fund: an investment that pools shareholders’money and invests it toward a specified goal. . . . The fund is governed by a Board of Trustees, which is responsible for protecting the interests of shareholders. . . . The fund is managed by FMR, which chooses the fund’s investments and handles its business affairs.”3 Investment companies are compensated as a percentage of assets under management. The more assets being managed, the more money the companies make. Therefore, companies strive to gain investors.
The Growth in Mutual Funds The growth in the number of mutual funds and the assets they hold is an incredible story. The number of mutual funds has grown rapidly in recent years. In 1980, there were 564 funds; at the beginning of 1997, there were approxi- mately 7,000 funds, and in January 2012, there were approximately 7,600 domestic funds.
The reasons for this great growth include investor demand for funds and low barriers to entry into the business. Consider this fact: More than 80 percent of all equity and hybrid funds, and 60 percent of all bond funds, were started after 1991.
Asset growth has also been dramatic, as shown in Figure 3-3. Assets of mutual funds were relatively small for many years, but exploded in the 1990s. Total assets of mutual fundsfirst exceeded $1 trillion in 1990, were almost $9 trillion in 2005, and were approxi- mately $11.6 trillion at the end of 2011. Most of today’s mutual funds were created after 1991.
3 As of early 2012, there were approximately 7,600 distinct domestic mutual funds with assets of approximately $11.6 trillion.15
Keep in mind that mutual funds can disappear. This is accomplished by merging a fund with another fund within the same company. It is typically done for poorly performing funds—the fund, and its record of bad performance, disappear forever. Between 2001 and 2007, almost 1,550 mutual funds were merged out of existence.
Checking Your Understanding
1.ETFs and closed-end funds both trade on exchanges. Why, then, are ETFs having a big negative impact on closed-end funds?
2.Why do you think mutual funds are by far the most popular type of investment company with investors as measured by assets under management?
Figure 3-3
Assets of Mutual Funds for Selected Years.
SOURCE: Investment Company Institute,2012 Investment Company Fact Book.
1980 1985 1990 1993 1996 1998 2000 2002 2003 2005 2006 2007 2008 2009 2010 2011 11.8 11.6 11.1
9.6 12.02
10.41
8.91
7.41 6.39 6.97
5.33
3.53
20.7 1.07 0.5 0.14
Trillions of dollars
15This does not count those mutual funds with different share classes, such as A, B, and C shares.
Types of Mutual Funds
Figure 3-4 shows the general range of mutual funds arrayed along a return-risk spectrum. As we can see, money market funds are on the lower end, and bond funds and balanced funds (which hold both bonds and stocks) are in the middle. Stock funds are on the upper-end of the risk-return spectrum.
There are four basic types of mutual funds:
l Money market mutual funds
l Equity (also called stock) funds
l Bond funds
l Hybrid or balanced funds (hold a combination of stocks and bonds)
These types of funds parallel our discussion in Chapter 2 of money markets and capital markets. Money market funds concentrate on short-term investing by holding portfolios of money market assets, whereas equity funds, bond funds, and hybrid funds concentrate on longer term investing by holding mostly capital market assets. We will discuss money market fundsfirst, and then consider the other three types together.
The distribution of total mutual fund assets among these four basic types is shown in Figure 3-5.
Figure 3-5
Percentage of Mutual Fund Assets by Type of Mutual Fund, 2010.
SOURCE: Investment Company Institute,2011 Investment Company Fact Book
24%
22%
48%
6%
Money market funds Bond funds Equity funds Hybrid funds Figure 3-4
Types of Mutual Funds Based on the Potential Risk-Reward Spectrum.
SOURCE: Adapted Loosely from the Vanguard Web Site.
Money market funds
Bond funds ranging from short maturities to long maturities
Hybrid funds (stocks and
bonds)
Large-cap stock funds
Small-cap stock funds
Specialized stock funds
International stock funds
Less risk
Less expected return
More risk More expected return Relation between risk and expected return for mutual funds
3 Of the roughly $11.6 trillion mutual fund assets at the beginning of 2012, about half was invested in equity funds, and about a quarter was in money market funds. This asset distribution among types of funds is fairly typical.16