The Early Twenty-First Century
chapter 3 Overview of Industry Structure
The typical open-end mutual fund has very limited internal resources, contracting out almost all of its activities. Thus an open-end mutual fund can be seen as a set of contracts between the trustees and other organizations which provide specialized services.
—Peter Fortune1 The mutual fund industry includes not only 90-million-plus individual and institutional investors who supply capital to be invested and 8,000 funds that invest it, but also thousands of other organizations.2 Most of these organizations provide required services—investment advice, distribution, customer service, custody, auditing, consulting, legal representation, securities prices and other information, and the like—to either investors or funds. Some are subcontractors, providing services to other service organizations. Some regulate the activities of the funds and their service providers. Finally, the funds and service providers have organized themselves into industry asso- ciations that educate and represent their membership. Collec- tively, these organizations make up the mutual fund industry.
Most of the organizations that comprise the industry are covered in detail in the chapters that describe the services they provide. This chapter sets the context for those more detailed discussions. It covers the funds themselves, and briefl y identi- fi es what the other entities in the industry do, how they relate to the fund, and, when available, the magnitude of their partici- pation in industry revenues.
Figure 3.1 shows these major groups of players and the fl ows of money that connect them. Investors supply the money that drives the entire industry when they purchase mutual fund shares. The funds use most of this money to purchase securi- ties in accordance with the stated investment objectives. As the funds purchase and sell securities, they exchange money in the capital markets with counterparties—i.e., the organizations
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from which they purchase securities, and to which they sell them. The issuers of these securities send money to the funds when they pay dividends or inter- est and when certain types of securities mature. Investors remove money from the funds when they redeem shares, and when they elect to take dividend and capital gains distributions from the funds in the form of cash.
The growth of the industry—measured by the value of assets under man- agement—is fueled by three sources. First, to the extent that investors pur- chase more than they redeem, they provide a net infl ow of funds. In fact, investors have done exactly that for 18 of the last 20 years through 2003 (1988 saw a net negative fl ow of $23 billion and 2003 saw a net negative fl ow of $42 billion).3 Second, many of the securities the funds hold appreci- ate in value, providing unrealized capital gains, or market appreciation. As Table 3.1 shows, during 2003, the increase in the value of mutual fund assets (from $6.4 trillion to slightly over $7.4 trillion) stemmed entirely from market appreciation. Finally, the fi xed-income securities held by the funds pay inter- est income, some of the equity securities pay dividends, and the funds realize net capital gains when they sell securities. The funds distribute almost all of these to the shareholders, to avoid having them taxed at the fund level. While shareholders historically have taken about one-third of these dividends and gains distributions in cash, they return two-thirds to the funds in the form of reinvestments. Recently, it appears that even a higher percentage is returned to the funds in the form of reinvestments. This is likely attributable to those shareholders who are investing for retirement.
Share Purchases
$ $$
Investors
$
$ Funds
$
Securities Issuers Capital Markets
Counterparties
Third Party Service Providers
Management Companies Brokers
and Other Intermediaries Commissions
Share Redemptions Dividends/Capital Gains
Purchase Settlements Sale Settlements
Fees
Fees
Dividends, Interest, Maturities Commissions & Fees
Fees
Fees Regulators
Industry Associations Fees
Dues
Dues
Board of Directors Fees
Figure 3.1 Major entities and money fl ows in the U.S. mutual fund industry.
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Overview of Industry Structure 37 Most of this increase in the value accrues to the fund shareholders. Some of it, however, is used to generate revenue for those organizations that provide service for the funds.
•
Management companies receive fees for the fund administration, invest- ment advisory, distribution, customer servicing, and other services that they provide.•
Directors are compensated by the funds for their services in looking after the interests of the shareholders.•
Third-party service providers of many sorts receive fees, either directly from the funds or indirectly through the management companies.•
Brokers and other fi nancial intermediaries receive fees in several dif- ferent ways. They may be compensated for the activities they carry out in distributing the funds to investors, either directly by the investors or indirectly by the funds. The funds also employ intermediaries to execute securities trades, for which they are compensated with commissions or spreads.•
Industry associations receive membership fees, or dues, from the funds or management companies.Table 3.1 Change in Asset Value of U.S. Mutual Funds in 2003 ($ billions)
Value of Assets as of January 1, 2003 $6,390
Net of Purchases and Sales by Investors in 2003 Equity Funds
Hybrid Funds Bond Funds Money Market Funds
$152
$33
$31 ($258)
Total Net Purchases ($42)
Fee and Expense Outfl ows (estimated) Service Fees
Distribution Charges Portfolio Transactions
($30 ) ($17 ) ($28 )
Total Fee and Expense Outfl ows ($75)
Dividends, Interest, and Net Capital Gains Earned on Investments
Paid in Cash to Investors
$1,241 ($100)
Net Appreciation $1,141
Value of Assets as of December 31, 2003 $7,414
Source: Investment Company Institute (www.ici.org), Strategic Insight Simfund, calculations explained within the chapter
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Many of these service providers pay fees in turn to organizations that pro- vide service to them, for example, when fund accounting organizations pay information vendors for transmissions of securities prices.
One group in Figure 3.1 is not connected to the funds by money fl ows, at least not directly. The regulators, primarily the Securities and Exchange Com- mission (SEC) and the National Association of Securities Dealers (NASD), are funded in other ways. The SEC’s funding derives from the general appro- priations of the federal government. Member fi rms fund NASD, but the fund- ing is unrelated to any particular segment of the securities industry in which fi rms participate.