chapter 10 financial dynamics of mutual funds viewing recommendations for windows: use the arial...

Chapter 10

Financial Dynamics of Mutual Funds

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Copyright © Houghton Mifflin Company. All rights reserved. 10–2

Sales Loads: Shareholder-Paid Distribution Fees

• No-load or waived loads– Prevalent in the direct and retirement channels

• Front-end load– Prevalent in the intermediary distribution channel on Class A

– Typically, a large portion of the load is re-allowed to the intermediary and a small portion is retained by the management company

– Low-loads on the front-end are found in the direct distribution channel on certain funds (e.g., specialized funds)


Sales Loads: Shareholder-Paid Distribution Fees (cont.)

• Back-end load (contingent deferred sales charge or CDSC)– Prevalent in the intermediary distribution channel

on Class B– Typically, a CDSC schedule sets a load amount

payable at redemption that declines over time to zero

– To pay the intermediary for its sales efforts, fund sponsors must finance the up-front commission and hope to recoup it over time


12b-1 Fees: Fund-Paid Distribution Fees Included in Annual Expenses for Shareholders

• Typically paid directly by the fund to finance distribution costs– Included in annual expenses passed through to fund shareholders– Maximum 12b-1 fee allowed by the SEC is 100 bp (75 bp distribution

charge and 25 bp service charge)

• Will likely vary by class of fund– Class A typically includes a high front-end load and a low 12b-1 fee– Class B typically includes a high 12b-1 fee and a back-end load in the form

of a CDSC– Class C typically combines a high 12b-1 fee and a modest CDSC for 1–2

years– Class I typically has no load and no 12b-1 fee

• All 12b-1 fees must be covered by a written plan– Approved initially by shareholders– Approved annually by independent directors


Other Fund-Paid Fees Included in Annual Expenses for Shareholders

• Management or advisory fees

– Usually the largest single fee paid by the fund

– Pays for portfolio management, research, trading desk, and related support

– Common structure involves breakpoint pricing

– All-inclusive fees are offered for some funds

– Performance fees may be part of other funds’ fee structure

• Transfer agent fees

– Pays for shareholder servicing and reporting and transaction processing

– Fees may take a variety of structures

– Considerations include external versus internal TA/single or multiple markets


Other Fund-Paid Fees Included in Annual Expenses for Shareholders (cont.)

• Other (miscellaneous) fund-paid fee

– Pricing and bookkeeping

– Audit and legal

– Custody expense

– Trustee fees


Expenses the FundSponsor Incurs

• Fund management and research expense– Portfolio management, investment research, trading, and

support

– This expense has the biggest impact on the fund’s success

• Distribution expense– Marketing, promotion, selling, and support

– May vary by size and age of fund

• Transfer agent and operations expense– Shareholder service and support

– Other operations (e.g., 401(k) record-keeping)


Economies of Scale

Factors That Help Factors That Hurt Fund Management

Fund Size Large Small Investment Objective Less Complex More Complex

Distribution

Fund Size Large and/or Mature Small and/or New Channel Strategy Intermediary Direct

Service

Fund Size Large Small Account Size Large Small


Position: “Fund ExpensesAre Too High”

• Total expenses of mutual funds have risen despite economies of scale that should be associated with a dramatically growing industry

• High expense ratios are associated not only with new funds but also with some mature funds

• Profit margins of fund management companies are too high, often exceeding 20%


Position: “Fund ExpensesAre Reasonable”

• There’s been a shift in the structure, not the amount, of costs– Loads (not included in fund expenses) have

declined and

– 12b-1 fees (included in fund expenses) have in part replaced loads

• There has been a shift from lower-fee money market and bond funds to higher-fee equity funds


Position: “Fund ExpensesAre Reasonable” (cont.)

• Median expense ratios for funds started before 1987 has gone down, indicating some economies of scale

• Profit margins are below peak levels and are reasonable compared to other high knowledge industries


Source: Investment Company Institute (ICI)

Structure of Fund Industry: Asset Composition


Largest mutual fund complexes by assets, 1990 versus 2000

1990 Rank

Fund Group Assets ($B)

Asset Share

2000 Rank

Fund Group Assets ($B)

Asset Share

1 Fidelity Investments 108.3 10.2% 1 Fidelity Investments 822.9 11.8%

2 Merrill Lynch 90.5 8.5% 2 Vanguard Group 563.8 8.1%

3 Shearson/IDS 75.2 7.0% 3 Capital Research (American Funds) 359.8 5.2%

4 Dreyfus Corp. 57.4 5.4% 4 Putnam Funds 264.7 3.8%

5 Vanguard Group 56.6 5.3% 5 MSDW/Van Kampen 226.8 3.3%

6 Franklin 44.8 4.2% 6 Janus/Berger 206.3 3.0%

7 Federated 44.0 4.1% 7 AMVESCAP PLC (AIM/INVESCO) 205.5 3.0%

8 Dean Witter 40.2 3.8% 8 Merrill Lynch 184.9 2.7%

9 Kemper 37.1 3.5% 9 Franklin Templeton 172.9 2.5%

10 Capital Research (American Funds) 34.0 3.2% 10 Salomon Smith Barney/Citi/Shearson 169.6 2.4%

Subtotal - Top 10: 588.1 55.1% 3,177.3 45.6%

Total - Top 25: 812.9 76.2% 4,945.4 71.0%

Structure of Fund Industry: Industry Concentration Over Past Decade


Mergers and Acquisitions Involving Fund Sponsors

• M&A activity increased throughout the 1990s

– Trend coincided with stock market rise and general growth in financial services

– 144 publicly reported M&A transactions analyzed in a Merrill Lynch study

• 3 main M&A categories analyzed in study include

– U.S. domestic transactions

– Cross-border transactions

– Foreign transactions (not discussed in the chapter)


Mergers and Acquisitions Involving Fund Sponsors (cont.)

• General M&A trends during the 1990s– Early 1990s

• Transactions among U.S. financial firms were main focus

• Intraindustry activity focused on fund sponsors being acquired

– Later in decade• Fund sponsors began to become intraindustry acquirers

• Pace of cross-border transactions increased

• Acquirers paid higher and higher prices in anticipation of continued strong growth of revenues and assets


The Case for Mergersin the Industry

• Economic factors—economies of scale– Overall asset size

– Lower cost to buy than build

– Reduction of overlapping costs

• Business factors– Product line extensions

– Distribution expansion

– Diversification


The Case for Mergersin the Industry (cont.)

• Legal factors

– Change in control terminates the advisor contract

– Acquisition does not guarantee contract renewal

– Need seller’s assistance to obtain required approvals


Case Study: Merger Rationale for Major Stakeholders

• Directors and shareholders– Fund performance

– Fees

– Competitive factors

• Intermediary distributors– Compensation

– Fund performance

– Product line


Case Study: Merger Rationale for Major Stakeholders (cont.)

• Fund company

– Economies of scale

– Fees

– Product line


American Guardian Best ManagementPatriot Growth Western Growth Industry Median

Distribution Channel: Intermediary Intermediary

Type of Funds Sold: Domestic Equity Domestic EquityGrowth/Cap. App. Growth/Cap. App.

Class A Class A

Transfer agent: Outsourced Internal

Size of Fund: $3B $2.5B

Current Fees (%):Advisory Fees 58 bp 44 bp 52 bp12b-1 Fees 25 bp (25bp to B/D) 35 bp (30bp to B/D) 25 bp (25bp to B/D)Service Fees 15 bp 19 bp 17 bpTotal Expense Ratio 98 bp 98 bp 94 bp

Load StructureFront-End 5% (4.5% to B/D) 5% (4.5% to B/D) 5% (4.5% to B/D)

Case Study: Exhibit 1


Newly Merged FundAmerican Patriot Growth Best Western Growth (1-Year Forward) $000 bp $000 bp $000 bp

Annualized Average Assets 3,000,000 2,500,000Projected Gross Sales 0 250,000

Revenue: Sales Loads, Net (50 bp) 0 0 1,250 5 Management Fees 17,400 58 11,000 44 12b-1 Fees, Net 0 0 1,250 5 Transfer Agent Fees 4,500 15 4,750 19Total Revenue 21,900 73 18,250 73

Expense: Fund Management 7,500 25 6,250 25 Sales Support 3,000 10 3,750 15 Transfer Agent 4,500 15 6,250 25Total Expense 15,000 50 16,250 65

Pretax Income 6,900 23 2,000 8After Tax Income (40% Tax) 4,140 14 1,200 5

After Tax Margin 18.9% 6.6%

Case Study: Exhibit 2: 1996 Pro-forma P&L


Newly Merged FundAmerican Patriot Growth Best Western Growth (1-Year Forward) $000 bp $000 bp $000 bp

Annualized Average Assets 3,000,000 2,500,000 6,000,000Projected Gross Sales 0 250,000 500,000

Revenue: Sales Loads, Net (50 bp) 0 0 1,250 5 2,500 4 Management Fees 17,400 58 11,000 44 30,600 51 12b-1 Fees, Net 0 0 1,250 5 0 0 Transfer Agent Fees 4,500 15 4,750 19 10,200 17Total Revenue 21,900 73 18,250 73 43,300 72

Expense: Fund Management 7,500 25 6,250 25 12,750 21 Sales Support 3,000 10 3,750 15 6,750 11 Transfer Agent 4,500 15 6,250 25 9,600 16Total Expense 15,000 50 16,250 65 29,100 48

Pretax Income 6,900 23 2,000 8 14,200 24After Tax Income (40% Tax) 4,140 14 1,200 5 8,520 14

After Tax Margin 18.9% 6.6% 19.7%

Case Study: Possible Exhibit 2 (Post-Merger)


Class A Class B

Initial investment $10,000 Initial investment $10,000 Growth rate 8% Growth rate 8% NPV discount rate 10% NPV discount rate 10% Sales charge 5.00% CDSC 5,5,4,4,3,2,1,0% Commission 4.50% Commission 4.50% 12b-1 fees 0.30% 12b-1 fees* 1.00% Broker re-allowance 0.30% Broker re-allowance 0.30% Advisory fee and other exp.

0.68% Advisory fee & other exp.

0.68%

*Converts to the A Share 12b-1 schedule

at the beginning of year 9

One Possibility

Q6B—Best American: Newly Merged Fund Inputs for Comparison of Share Class Pricing


A Share Initial investment $10,000 Sales charge 5.00% 12b-1 fees 0.30%Growth rate 8% Commission 4.50% Broker re-allowance 0.30%NPV discount rate 10% Advisory fee and other exp. 0.68%

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10Beginning investment (after load) $9,500 $10,167 $10,881 $11,644 $12,462 $13,337 $14,273 $15,275 $16,347 $17,495Net appreciation $667 $714 $764 $817 $875 $936 $1,002 $1,072 $1,148 $1,228 Shareholder ending value $10,167 $10,881 $11,644 $12,462 $13,337 $14,273 $15,275 $16,347 $17,495 $18,723

Sales charge $500 $0 $0 $0 $0 $0 $0 $0 $0 $012b-1 fees $30 $32 $34 $36 $39 $41 $44 $47 $51 $54 NPV of distribution-related expenses $527 $553 $578 $603 $627 $650 $673 $695 $717 $738 NPV of dist-related exp. retained $50 $50 $50 $50 $50 $50 $50 $50 $50 $50

Sales charge commissions $450 $0 $0 $0 $0 $0 $0 $0 $0 $012b-1 trailer $30 $32 $34 $36 $39 $41 $44 $47 $51 $54 NPV of broker compensation $477 $503 $528 $553 $577 $600 $623 $645 $667 $688

B Share Initial investment $10,000 CDSC 5,5,4,4,3,2,1,0% 12b-1 fees* 1.00%Growth rate 8% Commission 4.50% Broker re-allowance 0.30%NPV discount rate 10% Advisory fee and other exp. 0.68%

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10Beginning investment $10,000 $10,632 $11,304 $12,018 $12,778 $13,585 $14,444 $15,357 $16,328 $17,474Net appreciation $632 $672 $714 $760 $808 $859 $913 $971 $1,146 $1,227 Shareholder ending value $10,632 $11,304 $12,018 $12,778 $13,585 $14,444 $15,357 $16,328 $17,474 $18,700 CDSC on redemption $500 $500 $400 $400 $300 $200 $100 $0 $0 $0 Ending value with redemption $10,132 $10,804 $11,618 $12,378 $13,285 $14,244 $15,257 $16,328 $17,474 $18,700

12b-1 fees $103 $110 $117 $124 $132 $140 $149 $158 $51 $54 NPV of distribution-related expenses $94 $184 $272 $357 $439 $518 $594 $668 $690 $710 with redemption $548 $598 $573 $630 $625 $631 $645 $668 $690 $710 NPV of dist-related exp. retained ($384) ($321) ($260) ($200) ($143) ($88) ($34) $18 $18 $18 with redemption $70 $92 $41 $73 $43 $25 $17 $18 $18 $18

Sales charge commissions $450 $0 $0 $0 $0 $0 $0 $0 $0 $012b-1 trailer $31 $33 $35 $37 $40 $42 $45 $48 $51 $54 NPV of broker compensation $478 $505 $532 $557 $582 $605 $628 $650 $672 $693

* converts to the A Share 12b-1 schedule at the beginning of year 9

Q6B—Best American: Newly Merged Fund Comparison of Share Class Pricing

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