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 …
1. Mutual funds are primarily        4. Warren Buffet predicts that
   owned by:                            annual stock returns over the
    a. Individuals on their own         next 10 years will be:
    b. Individuals with retirement       a.   6.5%
       accounts                          b.   9.6%
                                         c.   12.3%
2. Mutual funds mostly invest in:
                                         d.   21.7%
    a. Stocks
    b. Bonds
    c. Notes (money market)          5. Past performance of stock funds
                                        generally predicts future returns.
3. What have been annual                 a. Yes
   returns (1926-2004):                  b. No
    a.   Small-cap stocks                c. Only low-performing funds
    b.   Large-cap stocks
    c.   Corporate bonds             6. Mutual fund investors say they
    d.   Treasury bills                 pay attention more to fees than
                                        to performance.
                                         a. True
                                         b. False
7. As a mutual fund investor, you            10. What is a no-load fund?
   are entitled to:                              a.   An unleveraged fund
    a. Prospectus (before you invest)            b.   A fund without sales charges
    b. Annual report (showing fund               c.   A fund without trading costs
       performance)                              d.   A fund without withdrawal fees
    c. Statements (showing breakdown
       of expenses / fees / trading costs)
                                             11. Think about your own largest
                                                mutual fund:
8. Mutual funds only impose a sales              a. Your current balance
   charge at the time you invest.
                                                 b. Fund‟s investment objectives
    a. True
                                                 c. Fund‟s sales charges, expense
    b. False                                        ratio, trading costs
                                                 d. Fund‟s performance last year
9. Rate that stock funds sell and
   replace stock (turnover) in their         12. Consider your car/vehicle:
   portfolios:
                                                 a. Its make, model, year
    a.   6%
                                                 b. Its cost, total miles, safety
    b.   56%                                        rating, gas efficiency
    c.   90%                                     c. You get our point.
    d.   153%
                                       US Households
                                              (112 million)

                                      55 million own mutual funds
                                      (90% have Internet access)



                                                              Retirement
                                 On own
                                                               Account
                                  52%
                                                                 48%

                          79%           29%                48%         52%
                        (broker)       (direct)           (IRAs)     (DC plans)



                                     Mutual funds ($9.5 T)
                                 Stocks 57%              Bonds 17%   Money Mkt 26%

ICI 2005 – US Retirement Market
ICI 2004 – US Household Ownership                                       FR Boston – Oct 2006
ICI 2001 – Profile of MF investors                                      Bogle – 60 Years Later (2005)
How are mutual funds organized?
      How a mutual fund works


Fund investors    Elect majority        Owners

                  Board of
                  directors
                                   ??
    Mutual
     fund        services
                               Management firm
  [portfolio]     fees
   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
   “Capturing benefits” - mutual fund gauntlet

(1) Portfolio performance
   Equity funds: average = stock market
   Can fund managers beat market?

(2) Fund expenses
   Sales 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 performance
   Investors practice “buy high, sell low”
   “Capturing benefits” - mutual fund gauntlet

(1) Portfolio performance
   Equity funds: average = stock market
   Can fund managers beat market?

(2) Fund expenses
   Sales 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 performance
   Investors practice “buy high, sell low”
   “Capturing benefits” - mutual fund gauntlet

(1) Portfolio performance
   Equity funds: average = stock market
   Can fund managers beat market?

(2) Fund expenses
   Sales 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 performance
   Investors practice “buy high, sell low”
Mutual fund performance
(the envelope please) …
                     MF performance

 Past decade (annual averages)

Stock market return           11.1%     Mutual fund
                                      expenses = 2.5%
Stock fund returns
                              8.6%
(after expenses)

Stock fund investor returns
                                      Investor trading
                              6.2%     losses = 2.4%
(dollar-weighted returns)
                   MF performance

Past decade (annual averages)
                                       $10,000 (10 years)
                                           = $28,651
Stock market return            11.1%

Stock fund returns                     $10,000 (10 years)
                               8.6%
(loads, fees, trading costs)               = $22,819
Stock fund investor returns
                               6.2%
(selection / timing losses)            $10,000 (10 years)
                                           = $18,249
“It‟s the costs, dummy”
      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 Buffett
                              Value investor who recommends
                              that average investor “just index”
Invest $1000/year
  for 40 years …
             Effect of costs (fees, trading)

                          Effects of Costs
          $700,000
          $600,000
          $500,000                                    5%
Returns




          $400,000                                    7%
          $300,000                                    9%
          $200,000                                    11%
          $100,000
                $0
                     10        20           30   40
                                    Years
What should I do …
                   Investor irrationality
                     •   Morningstar ***** does not outshine ***
“go with a winner”
                     •   Business magazine ratings foretell swoon
                     •   Investors over-react to volatility (up / down)
“grass is greener”   •   About half of funds disappeared in „90s
                     •   Short-term investors cost long-termers
                     •   Product differentiation increases mkt share
    “framing”        •   “Winner funds” increase group‟s assets
                     •   Load funds under-perform no-load funds
                     •   Investors pursue lower loads and
“disclosure salve”       commissions, not operating fees
                     •   Among index funds, “name brand” wins
                     •   Info overload leads to worse decisions
  “more is less”
                     •   Investors notice fees when buy, not hold
                   Investor irrationality
                     •   Morningstar ***** does not outshine ***
“go with a winner”
                     •   Business magazine ratings foretell swoon
                     •   Investors over-react to volatility (up / down)
“grass is greener”   •   Of 4800 equity funds, 2000 gone in „90s
                     •   Short-term investors cost long-termers
                     •   Product differentiation increases mkt share
    “framing”        •   “Winner funds” increase group‟s assets
                     •   Load funds under-perform no-load funds
                     •   Investors pursue lower loads and
“disclosure salve”       commissions, not operating fees
                     •   Among index funds, “name brand” wins
                     •   Info overload leads to worse decisions
  “more is less”
                     •   Investors notice fees when buy, not hold
                   Investor irrationality
                     •   Morningstar ***** does not outshine ***
“go with a winner”
                     •   Business magazine ratings foretell swoon
                     •   Investors over-react to volatility (up / down)
“grass is greener”   •   About half of funds disappeared in „90s
                     •   Short-term investors cost long-termers
                     •   Product differentiation increases mkt share
 “a good family”     •   “Winner funds” increase group‟s assets
                     •   Load funds under-perform no-load funds
                     •   Investors pursue lower loads and
“disclosure salve”       commissions, not operating fees
                     •   Among index funds, “name brand” wins
                     •   Info overload leads to worse decisions
  “more is less”
                     •   Investors notice fees when buy, not hold
                   Investor irrationality
                     •   Morningstar ***** does not outshine ***
“go with a winner”
                     •   Business magazine ratings foretell swoon
                     •   Investors over-react to volatility (up / down)
“grass is greener”   •   About half of funds disappeared in „90s
                     •   Short-term investors cost long-termers
                     •   Product differentiation increases mkt share
    “framing”        •   “Winner funds” increase group‟s assets
                     •   Load funds under-perform no-load funds
                     •   Investors pursue lower loads and
    “ECMH”               commissions, not operating fees
                     •   Among index funds, “name brand” wins
                     •   Info overload leads to worse decisions
  “more is less”
                     •   Investors notice fees when buy, not hold
                    Investor irrationality
                      •   Morningstar ***** does not outshine ***
“go with a winner”
                      •   Business magazine ratings foretell swoon
                      •   Investors over-react to volatility (up / down)
“grass is greener”    •   About half of funds disappeared in „90s
                      •   Short-term investors cost long-termers
                      •   Product differentiation increases mkt share
    “framing”         •   “Winner funds” increase group‟s assets
                      •   Load funds under-perform no-load funds
                      •   Investors pursue lower loads and
“disclosure salve”        commissions, not operating fees
                      •   Among index funds, “name brand” wins
                      •   Info overload leads to worse decisions
 “more is better”
                      •   Investors notice fees when buy, not hold
Some solutions …




         “I‟m not your monkey.”
                    Jon Stewart
           Re-tasking fund directors

           Actions affecting investor returns
Stock                   Corporate governance:
market          Attend to proxy voting, governance role

Fund                  Fund-manager conflicts:
expenses         Reduce advisor fees / prevent abuses

Investor                  Investor biases:
trading       Address marketing, fund choices, allocations
           Re-tasking fund directors

           Actions affecting investor returns
Stock                   Corporate governance:
market          Attend to proxy voting, governance role

Fund                  Fund-manager conflicts:
expenses         Reduce advisor fees / prevent abuses

Investor                  Investor biases:
trading       Address marketing, fund choices, allocations
           Re-tasking fund directors

           Actions affecting investor returns
Stock                   Corporate governance:
market          Attend to proxy voting, governance role

Fund                  Fund-manager conflicts:
expenses         Reduce advisor fees / prevent abuses

Investor                  Investor biases:
trading       Address marketing, fund choices, allocations
The “agitated” mutual fund investor




   Actual includes “exchanges” within fund group.
     SSRN studies – investor irrationality
                     •   Morningstar ***** does not outshine ***
“go with a winner”
                     •   Business magazine ratings foretell swoon
                     •   Investors over-react to volatility (up / down)
“grass is greener”   •   About half of funds disappeared in „90s
                     •   Short-term investors cost long-termers
                     •   Product differentiation increases mkt share
    “framing”        •   “Winner funds” increase group‟s assets
                     •   Load funds under-perform no-load funds
                     •   Investors pursue lower loads and
“disclosure salve”       commissions, not operating fees
                     •   Among index funds, “name brand” wins
                     •   Info overload leads to worse decisions
  “more is less”
                     •   Investors notice fees when buy, not hold
     SSRN studies – investor irrationality
                     •   Morningstar ***** does not outshine ***
“go with a winner”
                     •   Business magazine ratings foretell swoon
                     •   Investors over-react to volatility (up / down)
“grass is greener”   •   About half of funds disappeared in „90s
                     •   Short-term investors cost long-termers
                     •   Product differentiation increases mkt share
    “framing”        •   “Winner funds” increase group‟s assets
                     •   Load funds under-perform no-load funds
                     •   Investors pursue lower loads and
“disclosure salve”       commissions, not operating fees
                     •   Among index funds, “name brand” wins
                     •   Info overload leads to worse decisions
  “more is less”
                     •   Investors notice fees when buy, not hold
     SSRN studies – investor irrationality
                     •   Morningstar ***** does not outshine ***
“go with a winner”
                     •   Business magazine ratings foretell swoon
                     •   Investors over-react to volatility (up / down)
“grass is greener”   •   About half of funds disappeared in „90s
                     •   Short-term investors cost long-termers
                     •   Product differentiation increases mkt share
    “framing”        •   “Winner funds” increase group‟s assets
                     •   Load funds under-perform no-load funds
                     •   Investors pursue lower loads and
“disclosure salve”       commissions, not operating fees
                     •   Among index funds, “name brand” wins
                     •   Info overload leads to worse decisions
  “more is less”
                     •   Investors notice fees when buy, not hold
     SSRN studies – investor irrationality
                     •   Morningstar ***** does not outshine ***
“go with a winner”
                     •   Business magazine ratings foretell swoon
                     •   Investors over-react to volatility (up / down)
“grass is greener”   •   About half of funds disappeared in „90s
                     •   Short-term investors cost long-termers
                     •   Product differentiation increases mkt share
    “framing”        •   “Winner funds” increase group‟s assets
                     •   Load funds under-perform no-load funds
                     •   Investors pursue lower loads and
“disclosure salve”       commissions, not operating fees
                     •   Among index funds, “name brand” wins
                     •   Info overload leads to worse decisions
  “more is less”
                     •   Investors notice fees when buy, not hold
     SSRN studies – investor irrationality
                     •   Morningstar ***** does not outshine ***
“go with a winner”
                     •   Business magazine ratings foretell swoon
                     •   Investors over-react to volatility (up / down)
“grass is greener”   •   About half of funds disappeared in „90s
                     •   Short-term investors cost long-termers
                     •   Product differentiation increases mkt share
    “framing”        •   “Winner funds” increase group‟s assets
                     •   Load funds under-perform no-load funds
                     •   Investors pursue lower loads and
“disclosure salve”       commissions, not operating fees
                     •   Among index funds, “name brand” wins
                     •   Info overload leads to worse decisions
  “more is less”
                     •   Investors notice fees when buy, not hold
       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 Jenkins
                                 Wall Street Journal
                         Editorial - December, 2003
Some solutions …




         “I‟m not your monkey.”
                    Jon Stewart
         “Best practices”                           ICI
                                                   (1999, 2003)
                                                                  MFDF
                                                                     (2004)

               Independent chair                 “Lead” ID          Yes
               “ID” definition                  No IA execs       Wait 5 yrs
               IDs majority                         2/3             75%
   Director
               Independent legal counsel            Yes             Yes
independence
               IDs nominate, select                 Yes              --
               IDs set own pay                      Yes             Yes
               D&O insurance                        Yes              --
               Independent committee               Audit           Review
Management
             Review process                     Executive mtg      All info
arrangements
               Outside consultant                    --             Yes
  Portfolio    Seek best execution, MFN fees           --            Yes
   trading     “Directed brokerage”                    --         Not permit
 Portfolio     Standing committee                      --            Yes
 valuation     Stay on top                             --            Yes
 Conflicts     Directors own funds oversee          Yes              Yes
 of interest   Self-evaluation / ID education   Questionnaire        Yes
            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 duties
  Specify functions / informed / enforceable duties
  Courts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directors
  Self-regulatory organization (like NASD, PCAOB)
  Minimum standards / disciplinary apparatus
            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 duties
  Specify functions / informed / enforceable duties
  Courts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directors
  Self-regulatory organization (like NASD, PCAOB)
  Minimum standards / disciplinary apparatus
            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 duties
  Specify functions / informed / enforceable duties
  Courts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directors
  Self-regulatory organization (like NASD, PCAOB)
  Minimum standards / disciplinary apparatus
            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 duties
  Specify functions / informed / enforceable duties
  Courts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directors
  Self-regulatory organization (like NASD, PCAOB)
  Minimum standards / disciplinary apparatus
            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 duties
  Specify functions / informed / enforceable duties
  Courts to “guard the guards” [Juvenal, 160AD]
Professional, certified independent directors
  Self-regulatory organization (like NASD, PCAOB)
  Minimum standards / disciplinary apparatus