Sunday, March 8, 2009


As we approach the 85th birthday of mutual funds in the US, the thought occurred to me that in our sound bite world there may be numerous misperceptions about mutual funds. Some of these misperceptions could lead to legislators not fully understanding mutual funds, even though many of them use funds themselves to avoid the potential conflicts-of-interest of owning individual securities. The same could be true for the members of the Fourth Estate. (The term Fourth Estate term comes from the French Revolution, where the press was going to be recognized in the new perfect government after the revolution. I will let others determine whether this is an appropriate term in the US today.)

My concern is that individual investors’ misperceptions, either directly or through the influence of the Fourth Estate, could be depriving them of useful investment instruments to fulfill their needs, particularly those fortunate enough to fit into a category called Ultra High Net Worth (over $25 million to invest).

The fund business can take pride that in 1924 some professional fiduciaries came up with funds that had redeemable features. Prior to that time all funds here and in Europe were closed to redemptions. The first fund organized as an investment company began in Belgium in the 19th Century, and the movement quickly found acceptance in the UK. However, the principle of gathering assets from (usually wealthy) individuals, to be directed by one or a small group of leaders, predates organized funds by a couple hundred years. They were called by their legal name as a joint stock company. The great exploration companies, such as the Dutch East India Company that developed New York City and other places within our country, as well as various locations in Asia, were joint stock companies.

The principle of banding together in perilous journeys was seen in the development of our West, as well as the camel caravans of biblical times, where the members paid to be led and followed the orders of the leader. The main lesson from this history is that it is common to seek a manager to guide you through dangerous times and places. Becoming part of a group creates an asset base large enough to attract some of the best leaders available.

One of the major misperceptions about mutual funds today is how big they are. Even after substantial market declines and a lot of redemptions, the open end fund business has total net assets in excess of $9 trillion dollars. This amount is larger than the US deficit, as well as all of the goods and services of most countries. This total excludes the kissing cousins of closed end funds, variable annuities and commingled vehicles of various institutions that follow many of the same practices of open end mutual funds. On a world-wide basis, the amount of money invested in redeemable funds is in the neighborhood of $20 trillion. Who are the holders of mutual fund shares? In the UK, some of the misinformed press believe that funds are for those families headed by a man wearing a soft cap rather than a top hat. As with many British notions, this is a class-oriented comment that is probably statistically out-of-date, and way outdated in the US. The penetration of mutual funds into American households is close to 50%, where it has been for some time. Many of the owners of funds are women, and serve as the investment decision-makers for their households. As an investment advisor to individuals and families that are within the top 1% of our country’s wealth, I can testify that many very rich people own mutual funds. Because of my work with various non-profits, I can state quite a number of billionaires are very knowledgeable about mutual funds, and therefore probably use mutual funds.

Often one hears from various “talking heads” that mutual funds are doing this or that. While some funds may well be doing whatever the commentator is bashing, the plain truth is that the fund business is much broader than any single investment objective or practice. Of the $9 trillion assets, $3.2 trillion is invested in various types of Money Market funds. Another $1 trillion is invested in Long-term, Taxable Fixed Income funds, and at last count $832 billion in Tax-exempt securities. The last figure suggests that a number of wealthy households own mutual funds. Many other wealthy investors use Money Market funds (with a much better record of safety) as alternatives to banks. Thus, over half of today’s funds are fixed income funds. This total excludes the $789 billion in Hybrid funds that own both stocks and bonds.

Stock or Equity funds are quite diverse in their choices of securities and techniques; such as mutual funds that mimic some hedge funds by shorting stocks, to others that are designed to meet court-designated legal lists of high-quality common stocks. If one looks at the nine investment objective classifications that are pure equity, each totaling over $100 billion dollars in assets, six of them of them have a conservative or middle of the road orientation. The largest single investment objective is Large Market Capitalization/Value-Oriented portfolios, with $296 billion in assets. The second largest investment objective category is the $288 billion in funds who attempt to track the S&P 500 index. This is an interesting group, often the subject of not particularly accurate media reporting about the group not beating the market. They are designed to replicate the S&P500, not surpass it. Representing only 8.8% of equity-oriented funds, I believe a disproportionate share of these assets is owned by various types of fiduciary institutions and members of academia.

The largest category that fits the traditional view of mutual funds is the large cap, growth-oriented equity funds who seek large-scale growth of earnings and valuations. The next two investment objective classifications are ones that do not accept that the market moves within specific capitalization bands; large, midcap, or small. Multi-cap Core Equity with $270 billion is as middle of the road as one can get, without an overabundance in size categories as well as growth or value oriented stocks. Slightly more aggressive is the Multi-cap Growth oriented portfolios, which is a bit more venturesome. The four other remaining investment objectives with over $100 billion in assets are, in size order, (1) Large Cap Core Equity, (2) International Multi-Cap Growth, (3) Small Cap Core Equity and (4) International Multi-cap Core Equity. All in all, investors are pretty conservative, especially as many have significant market related assets outside of their fund investment.

The preference for active management is easily understood: the average S&P 500 fund in the last ten years (ending in February) is down -3.88%. Of the twenty US diversified investment objectives, 15 of them beat the S&P500 index funds; 8 by going up and 7 by losing less. The same thing could be said by the twenty Sector-Oriented funds; 11 gained and 2 declined less. A caveat should be noted that the fund data base used by my old firm, Lipper Inc., has a survivorship bias. Funds that are no longer available are dropped from the calculations. Thus, the clunkers drop out. Nevertheless, I believe that the general observations made here are valuable.

I believe it was Yogi Berra who said that one can see a lot by observing. When looking at the leaders and laggards for the first two months of 2009, I see widely-held fund types that are in contradiction to the bulk of the way most investors have their assets. As a contrarian, I think it is likely that the leaders and laggards will be reversing positions in the future.

For the first two months of 2009, dedicated Short Biased funds, (the mutual fund business’s answer to the growth of retail oriented hedge funds) took the first twenty-five places as the leading fixed income funds. The laggards were a more diverse group with Financial Service funds getting the four worst performances, and 6 of the twenty-five largest decliners. On the fixed income side the leaders for the first two months were the Loan Participation funds. These are funds that buy loans typically from banks on a non-recourse basis, at a substantial discount from their face value. Another type of leader later in the period was the High Current Yield funds, if you will “junk” bonds. What is significant about these two is that they are attracting risk-assuming equity types of managers and investors.

My, only somewhat biased, conclusion is that mutual funds are often misperceived, can teach us about the markets, and are an appropriate vehicle for all types of investors.

No comments: