mutual funds: an investment primer
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Mutual Funds: An investment primer. What’s a mutual fund? Where do returns come from? Is there a strategy that works?. A pop quiz …. 4.Warren Buffet predicts that annual stock returns over the next 10 years will be: 6.5% 9.6% 12.3% 21.7% - PowerPoint PPT PresentationTRANSCRIPT
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Mutual Funds:An investment primer
What’s a mutual fund?Where do returns come from? Is there a strategy that works?
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A pop quiz …
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1. Mutual funds are primarily owned by:a. Individuals on their ownb. Individuals with retirement
accounts
2. Mutual funds mostly invest in:a. Stocksb. Bondsc. Notes (money market)
3. What have been annual returns (1926-2004):a. Small-cap stocksb. Large-cap stocks c. Corporate bondsd. Treasury bills
4. Warren Buffet predicts that annual stock returns over the next 10 years will be:a. 6.5%b. 9.6%c. 12.3%d. 21.7%
5. Past performance of stock funds generally predicts future returns. a. Yesb. Noc. Only low-performing funds
6. Mutual fund investors say they pay attention more to fees than to performance.a. Trueb. False
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7. As a mutual fund investor, you are entitled to:a. Prospectus (before you invest)b. Annual report (showing fund
performance)c. Statements (showing
breakdown of expenses / fees / trading costs)
8. Mutual funds only impose a
sales charge at the time you invest. a. Trueb. False
9. Rate that stock funds sell and replace stock (turnover) in their portfolios:a. 6%b. 56%c. 90%d. 153%
10. What is a no-load fund? a. An unleveraged fundb. A fund without sales chargesc. A fund without trading costsd. A fund without withdrawal fees
11. Think about your own largest mutual fund:a. Your current balanceb. Fund’s investment objectivesc. Fund’s sales charges, expense
ratio, trading costs d. Fund’s performance last year
12. Consider your car/vehicle: a. Its make, model, yearb. Its cost, total miles, safety
rating, gas efficiencyc. You get our point.
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ICI 2005 – US Retirement MarketICI 2004 – US Household OwnershipICI 2001 – Profile of MF investors
US Households(112 million)
Mutual funds ($9.5 T)
RetirementAccount
48%
55 million own mutual funds(90% have Internet access)
79%(broker)
On own52%
29%(direct)
48%(IRAs)
52%(DC plans)
Stocks 57% Money Mkt 26%Bonds 17%
FR Boston – Oct 2006 Bogle – 60 Years Later (2005)
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How are mutual funds organized?
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How a mutual fund works
Elect majority
??
services
fees
Mutualfund
[portfolio]
Fund investors
Board of directors
Management firm
Owners
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Mutual fund – “tool of capitalism”
“Capitalism ought to be about capturing the benefits of equity investment for those who put up the capital and take the risks.”
Jack Bogle,
founder of Vanguard
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“Capturing benefits” - mutual fund gauntlet
(1) Portfolio performanceEquity funds: average = stock marketCan fund managers beat market?
(2) Fund expensesSales load (front-end / back-end)Marketing fees (from assets - Rule 12b-1)Management fees (percent of assets)Portfolio trading costs (brokerage fees, spreads, opportunity costs)
(3) Trading losses (or gains)Marketing touts funds’ past performanceInvestors practice “buy high, sell low”
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“Capturing benefits” - mutual fund gauntlet
(1) Portfolio performanceEquity funds: average = stock marketCan fund managers beat market?
(2) Fund expensesSales load (front-end / back-end)Marketing fees (from assets - Rule 12b-1)Management fees (percent of assets)Portfolio trading costs (brokerage fees, spreads, opportunity costs)
(3) Trading losses (or gains)Marketing touts funds’ past performanceInvestors practice “buy high, sell low”
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“Capturing benefits” - mutual fund gauntlet
(1) Portfolio performanceEquity funds: average = stock marketCan fund managers beat market?
(2) Fund expensesSales load (front-end / back-end)Marketing fees (from assets - Rule 12b-1)Management fees (percent of assets)Portfolio trading costs (brokerage fees, spreads, opportunity costs)
(3) Trading losses (or gains)Marketing touts funds’ past performanceInvestors practice “buy high, sell low”
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Mutual fund performance(the envelope please) …
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MF performance
Past decade (annual
averages)Stock market return 11.1%
Stock fund returns(after expenses) 8.6%
Stock fund investor returns (dollar-weighted returns)
6.2%
Mutual fund expenses = 2.5%
Investor tradinglosses = 2.4%
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MF performance
Past decade (annual
averages)Stock market return 11.1%Stock fund returns(loads, fees, trading costs)
8.6%
Stock fund investor returns (selection / timing losses)
6.2%
$10,000 (10 years) = $28,651
$10,000 (10 years) = $22,819
$10,000 (10 years) = $18,249
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“It’s the costs, dummy”
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Role of “independent” directors
“When the managers care about fees and the directors don’t, guess who wins? Negotiating with oneself seldom produces a barroom brawl.”
Warren BuffettValue investor who recommends
that average investor “just index”
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Invest $1000/yearfor 40 years …
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Effect of costs (fees, trading)
Effects of Costs
$0$100,000$200,000$300,000$400,000$500,000$600,000$700,000
10 20 30 40
Years
Ret
urns
5%7%9%11%
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What should I do …
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Investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
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Investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • Of 4800 equity funds, 2000 gone in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
![Page 22: Mutual Funds: An investment primer](https://reader035.vdocuments.net/reader035/viewer/2022062410/56815ccb550346895dcad76b/html5/thumbnails/22.jpg)
Investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“a good family”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
![Page 23: Mutual Funds: An investment primer](https://reader035.vdocuments.net/reader035/viewer/2022062410/56815ccb550346895dcad76b/html5/thumbnails/23.jpg)
Investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“ECMH”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
![Page 24: Mutual Funds: An investment primer](https://reader035.vdocuments.net/reader035/viewer/2022062410/56815ccb550346895dcad76b/html5/thumbnails/24.jpg)
Investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is better”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
![Page 25: Mutual Funds: An investment primer](https://reader035.vdocuments.net/reader035/viewer/2022062410/56815ccb550346895dcad76b/html5/thumbnails/25.jpg)
Some solutions …
“I’m not your monkey.”Jon Stewart
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Re-tasking fund directors
Actions affecting investor returns
Stock market
Corporate governance: Attend to proxy voting, governance role
Fund expenses
Fund-manager conflicts:Reduce advisor fees / prevent abuses
Investor trading
Investor biases:Address marketing, fund choices, allocations
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Re-tasking fund directors
Actions affecting investor returns
Stock market
Corporate governance: Attend to proxy voting, governance role
Fund expenses
Fund-manager conflicts:Reduce advisor fees / prevent abuses
Investor trading
Investor biases:Address marketing, fund choices, allocations
![Page 28: Mutual Funds: An investment primer](https://reader035.vdocuments.net/reader035/viewer/2022062410/56815ccb550346895dcad76b/html5/thumbnails/28.jpg)
Re-tasking fund directors
Actions affecting investor returns
Stock market
Corporate governance: Attend to proxy voting, governance role
Fund expenses
Fund-manager conflicts:Reduce advisor fees / prevent abuses
Investor trading
Investor biases:Address marketing, fund choices, allocations
![Page 29: Mutual Funds: An investment primer](https://reader035.vdocuments.net/reader035/viewer/2022062410/56815ccb550346895dcad76b/html5/thumbnails/29.jpg)
The “agitated” mutual fund investor
Actual includes “exchanges” within fund group.
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SSRN studies – investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
![Page 31: Mutual Funds: An investment primer](https://reader035.vdocuments.net/reader035/viewer/2022062410/56815ccb550346895dcad76b/html5/thumbnails/31.jpg)
SSRN studies – investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
![Page 32: Mutual Funds: An investment primer](https://reader035.vdocuments.net/reader035/viewer/2022062410/56815ccb550346895dcad76b/html5/thumbnails/32.jpg)
SSRN studies – investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
![Page 33: Mutual Funds: An investment primer](https://reader035.vdocuments.net/reader035/viewer/2022062410/56815ccb550346895dcad76b/html5/thumbnails/33.jpg)
SSRN studies – investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
![Page 34: Mutual Funds: An investment primer](https://reader035.vdocuments.net/reader035/viewer/2022062410/56815ccb550346895dcad76b/html5/thumbnails/34.jpg)
SSRN studies – investor irrationality
“go with a winner”• Morningstar ***** does not outshine ***• Business magazine ratings foretell swoon
“grass is greener”• Investors over-react to volatility (up / down) • About half of funds disappeared in ‘90s• Short-term investors cost long-termers
“framing”• Product differentiation increases mkt share• “Winner funds” increase group’s assets• Load funds under-perform no-load funds
“disclosure salve”• Investors pursue lower loads and
commissions, not operating fees• Among index funds, “name brand” wins
“more is less”• Info overload leads to worse decisions• Investors notice fees when buy, not hold
![Page 35: Mutual Funds: An investment primer](https://reader035.vdocuments.net/reader035/viewer/2022062410/56815ccb550346895dcad76b/html5/thumbnails/35.jpg)
Investor cognitive biases
“If investors gobble up all the information that Lipper, Morningstar and publications like this newspaper lay before them, but still insist on ignoring fees and chasing the “hot” fund du jour, who’s to tell them they can’t?”
Holman JenkinsWall Street Journal
Editorial - December, 2003
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Some solutions …
“I’m not your monkey.”Jon Stewart
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“Best practices” ICI (1999, 2003)
MFDF (2004)
Director independence
Independent chair “ID” definitionIDs majorityIndependent legal counselIDs nominate, selectIDs set own payD&O insurance
“Lead” IDNo IA execs
2/3YesYesYesYes
YesWait 5 yrs
75%Yes--
Yes--
Management arrangements
Independent committeeReview processOutside consultant
AuditExecutive mtg
--
ReviewAll info
Yes
Portfolio trading
Seek best execution, MFN fees“Directed brokerage”
----
YesNot permit
Portfolio valuation
Standing committeeStay on top
----
YesYes
Conflicts of interest
Directors own funds overseeSelf-evaluation / ID education
YesQuestionnaire
YesYes
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Some solutions …
More disclosure
SEC and NASD / specify disclosure under ERISA“Informed” investors fend for themselves
Expanded “best practices”Recognize investor biases– “behavioral” advisors Compensate for biases – fund design, marketing
Federal fiduciary dutiesSpecify functions / informed / enforceable dutiesCourts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directorsSelf-regulatory organization (like NASD, PCAOB)Minimum standards / disciplinary apparatus
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Some solutions …
More disclosure
SEC and NASD / specify disclosure under ERISA“Informed” investors fend for themselves
Expanded “best practices”Recognize investor biases– “behavioral” advisors Compensate for biases – fund design, marketing
Federal fiduciary dutiesSpecify functions / informed / enforceable dutiesCourts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directorsSelf-regulatory organization (like NASD, PCAOB)Minimum standards / disciplinary apparatus
![Page 40: Mutual Funds: An investment primer](https://reader035.vdocuments.net/reader035/viewer/2022062410/56815ccb550346895dcad76b/html5/thumbnails/40.jpg)
Some solutions …
More disclosure
SEC and NASD / specify disclosure under ERISA“Informed” investors fend for themselves
Expanded “best practices”Recognize investor biases– “behavioral” advisors Compensate for biases – fund design, marketing
Federal fiduciary dutiesSpecify functions / informed / enforceable dutiesCourts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directorsSelf-regulatory organization (like NASD, PCAOB)Minimum standards / disciplinary apparatus
![Page 41: Mutual Funds: An investment primer](https://reader035.vdocuments.net/reader035/viewer/2022062410/56815ccb550346895dcad76b/html5/thumbnails/41.jpg)
Some solutions …
More disclosure
SEC and NASD / specify disclosure under ERISA“Informed” investors fend for themselves
Expanded “best practices”Recognize investor biases– “behavioral” advisors Compensate for biases – fund design, marketing
Federal fiduciary dutiesSpecify functions / informed / enforceable dutiesCourts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directorsSelf-regulatory organization (like NASD, PCAOB)Minimum standards / disciplinary apparatus
![Page 42: Mutual Funds: An investment primer](https://reader035.vdocuments.net/reader035/viewer/2022062410/56815ccb550346895dcad76b/html5/thumbnails/42.jpg)
Some solutions …
More disclosure
SEC and NASD / specify disclosure under ERISA“Informed” investors fend for themselves
Expanded “best practices”Recognize investor biases– “behavioral” advisors Compensate for biases – fund design, marketing
Federal fiduciary dutiesSpecify functions / informed / enforceable dutiesCourts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directorsSelf-regulatory organization (like NASD, PCAOB)Minimum standards / disciplinary apparatus