When the chairman of a Washington, D.C., trade group takes "the opportunity to confront some misconceptions with reality," it's usually time to get out the bull meter.
This was my expectation at an industry conference last week where Terry Glenn, president of
Merrill Lynch Mutual Funds
and chairman of the
Investment Company Institute
, the trade organization for fund management companies, explored some basic "facts" about mutual funds. (See a transcript of his speech,
I was pleasantly surprised that the bull meter barely registered and that, for the most part, Glenn provided a sorely needed expose of some mutual fund myths that have recently gained public acceptance.
ICI Fact #1: Most Fund Shareholders Trade Infrequently
How can this be? The ICI's
own data show annualized redemption rates of 39.3% in March 2001, up from 37.8% in March 2000. This suggests that the average shareholder keeps his shares for only two and a half years.
As Glenn explained, however, redemption rates can hide the distorting effect of a small number of high turnover shareholders. Consider a fund with 100% of its shareholders holding their shares for seven years. It would have a redemption rate of 14%. But this balloons to 38% if just 2% of those shareholders redeem their shares monthly.
The ICI recently published
data from a 1999 study showing that 82% of households that own mutual funds did not redeem any shares in 1998, and another 9% redeemed shares only once.
Source: Investment Company Institute
Why are shareholders' true holding periods important? Because mutual funds' best customers are long-term investors, and they may go elsewhere if funds develop a reputation as catering to short-term traders.
The image of mutual funds also has political repercussions. A pending House bill that would defer taxes on capital gains distributed by funds is more likely to pass if
views funds in a positive light as long-term investment vehicles.
campaign to privatize Social Security succeeds, eligible investments will have to be selected. Mutual funds will stand less chance of capturing the lion's share of more than $1 trillion in new Social Security assets if they have a reputation as account-churning machines.
ICI Fact #2: Mutual Fund Shareholders Do Not Drive the Stock Market
This is another image problem for the industry. The witch hunt for culprits for the market's recent volatility has assigned mutual funds an unfair share of the blame.
As Glenn pointed out, both anecdotal and empirical evidence contradict popular and longstanding charges that mutual fund flows cause market volatility. He cited a recent
report that found "little evidence that mutual fund investors have been a destabilizing force in the U.S. equity market." Other academic studies have reached the same conclusion.
To illustrate Glenn's point, in year 2000 investors purchased a record $309 billion in equity mutual funds, despite the
Nasdaq Composite Index's
39% drop, its largest in 30 years, and the
Dow Jones Industrial Average
6% decline, its largest in 20 years. In 1999 the Nasdaq rose 86%, and the Dow 25%, yet investors purchased only $188 billion in equity fund shares.
Although shareholders might not care if funds have a reputation as moving markets, Congress does. As discussed above, tax cuts for fund shareholders and the investment of private Social Security accounts in mutual funds may lose support if mutual funds are perceived as a threat to market stability.
ICI Fact #3: Most Fund Sales Are Made Through a Third Party
If you bought fund shares through a bank, broker, insurance agent or financial planner, you probably aren't surprised that many fund investors buy their shares this way. But this fact has been frequently ignored and misunderstood by prognosticators during the past decade.
The press was replete in the 1990s with stories about the inevitable triumph of no-load funds sold directly to investors over inferior load funds sold through intermediaries. Given a choice between two otherwise identical funds, investors would learn never to choose the load version, right?
Wrong. During the past 10 years, Glenn notes, although sales through traditional brokers have declined, direct sales to investors have declined even more. Meanwhile, the sale of funds through new channels, such as fund supermarkets, banks, insurance companies and financial planners have skyrocketed.
In a perfect world, no one would use -- and pay for -- these intermediaries. We would all be well-informed, self-directed investors. But that's not the world we do, or ever will, live in.
Most fund shareholders invest through intermediaries and pay for the privilege because for one unfortunate reason or another, they have not achieved investing grace. They choose to live in an intermediary market and won't be moving any time soon.
Industry critics attack front-end commissions and castigate funds for charging 12b-1 fees. But if these charges disappeared, intermediaries would stop selling mutual funds and migrate to riskier, more expensive and possibly lower-performing investment products.
ICI Fact #4: Asset Concentration Has Changed Only Marginally
The 1990s were supposed to be the consolidation decade for the mutual fund industry, which raised the specter of monopolies by large fund companies. The facts suggest the opposite.
The share of fund assets held by the five largest fund complexes declined from 37% in 1990 to 34% in 2000, according to Glenn. The market share of the top-10 and top-25 complexes also declined during that period. At the same time, the number of mutual fund complexes increased during the decade from 464 to 629.
So the fund industry poses no immediate threat of becoming a traditional monopoly with a few huge players colluding on prices and services. But the industry does need to become more sensitive to its monopolistic tendencies.
Specifically, the mutual fund industry has long exhibited the characteristics of "monopolistic competition." Monopolistic competition exists when market players compete based on brand identification and features such as quality of service (this concept is explained in a June 2000
report on mutual fund fees by the
General Accounting Office
). The GAO found that the mutual fund industry was a textbook case of monopolistic competition.
In contrast, perfect competition among providers of commodity-like products begets competition based on price. This is why the pricing of money market funds, which are more difficult to differentiate, is far more competitive than for bond and stock funds.
Thus, Glenn is correct that the lack of asset concentration among a few firms connotes a competitive industry, but this competition won't necessarily drive down prices. Hence the GAO's conclusion that although the fund industry is competitive, it "generally does not attempt to compete on the basis of fees." Which leads us to ICI Fact #5.
ICI Fact #5: Vibrant Competition Has Produced Substantially Lower Costs
OK, so four out of five isn't bad. As is self-evident, this isn't a "fact," but a hypothesis. And a questionable one at that. Even the "fact" contained in the hypothesis -- that fund costs have gone down -- is highly dubious.
Glenn claims that, since 1980, the average cost of investing in equity, bond and money market funds has declined 40%, 29% and 24%, respectively. What he doesn't explain is how the
Securities and Exchange Commission
concluded in its
own study that fund fees had risen by nearly 20% during the same period.
These dueling findings bear out my Jan. 23
observation that the direction in which you believe fund fees have headed during the past two decades depends on the assumptions used, including whether one should weight fees by fund sales and how one treats the transition to 12b-1 fees from sales loads.
Glenn's "fact" also is suspect because the ICI ignores transaction costs. Transaction costs are brokerage commissions plus the spread between the
ask price that funds pay each time they purchase stocks. To their discredit, the SEC and GAO also ignored these costs because they are not included in funds' expense ratios.
It's not that the data aren't available. Two studies found that in the early 1990s the average stock fund paid transaction costs equal to 0.28% and 0.48% of assets. Around that time, funds turned over only about two-thirds of their portfolios each year.
Average turnover has since increased to about 100% of a fund's portfolio each year, and estimates of current transaction costs range from 0.7% to 1.6%. (See analysis of fund transaction costs by
Russ Wermers and
Funds with higher turnover or ones that trade in small-cap stocks have even higher transaction costs. These costs may exceed a fund's entire expense ratio, making the ICI/SEC/GAO debate about whether expense ratios have gone up or down somewhat trivial.
Funds also hide expenses by characterizing some fees as brokerage. Funds pay what are known as soft dollars, which refer to the part of a commission in excess of the lowest possible rate. The excess pays for investment reports,
terminals and other investment services that would normally be paid for by the fund's manager. And these services do not even have to benefit the fund whose brokerage paid for them. Soft dollars even pay for nonresearch services, such as custody of fund assets.
Each of these costs would normally be included in the expense ratio and openly disclosed in funds' fee tables, but by paying for them with soft dollars, funds hide them from view and effectively remove them from consideration in so-called fee studies.
Fact and Fiction
Despite his attempt to pass off fund industry fiction regarding fees as fact, Glenn made some important points that investors and regulators need to understand.
Although they harbor their share of market timers, mutual funds are the investment vehicles of choice for U.S. long-term investors. And they are by no means a destabilizing force in the markets.
Fund fees may be too high, but they're still lower than most alternatives, and infinitely more transparent and understandable. Fund sales charges might be viewed as wasted money in some theoretical marketplace, but in the real world these charges make funds available to investors who otherwise would pay more and make worse investments.
Mutual funds offer, hands down, the best investment options available to America's long-term investors. And that's a fact.
Mercer Bullard, a former assistant chief counsel at the Securities and Exchange Commission, is the founder and CEO of Fund Democracy, a mutual fund shareholder advocacy group in Chevy Chase, Md. He welcomes your feedback at