Mutual Fund Industry Handbook

A Comprehensive Guide for Investment Professionals

Lee Gremillion

• Publisher: Wiley
• Year: 2012
• Print ISBN: 9780471736240
• eBook ISBN: 9781118428726
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

"The Mutual Fund Industry Handbook is a remarkably important work... I am profoundly impressed by the broad and comprehensive sweep of information and knowledge that this book makes available to industry participants, college and business school students, and anyone else with a serious interest in this industry."
-- From the Foreword by John C. Bogle President, Bogle Financial Markets Research Center Founder and former chief executive, The Vanguard Group

A Foreword by John C. Bogle, founder of The Vanguard Group and one of the most respected leaders in the mutual fund industry, sets the stage for this authoritative book that explains the complexities of the phenomenal industry in simple terms. Investors like the fact that mutual funds offer professional management, easy diversification, liquidity, convenience, a wide range of investment choices, and regulatory protection. Mutual Fund Industry Handbook touches on all of those features and focuses on the diverse functions performed in the day-to-day operations of the mutual fund industry. You'll learn about:

• Front-office functions-analysis, buying, and selling.
• Back-office functions, including settlement, custody, accounting, and reporting.
• Commission structures-front-end loads, back-end loads, or level loads.
• The various fund categories used by the Investment Company Institute, Morningstar, and Lipper.
• The roles played by fund managers, investment advisors, custodial banks, distributors, transfer agents, and other third-party service providers.

If you want a definitive reference on the mutual fund industry, this is the book for you.

chapter 1

Introduction to the Industry

In 1980, only one in 16 households invested in mutual funds; at the end of 2003, almost one of every two U.S. households is invested in mutual funds. More than a third of mutual fund assets are owned in accounts saving for retirement.

—Investment Company Institute’s 2004 Mutual Fund Fact Book1

Mutual Funds—Big Business by Any Standard

Open any issue of the Wall Street Journal, or the business section of any major newspaper, and you will find several pages of densely packed print labeled “Mutual Funds.” These pages may list the names, prices, yields, and other key attributes of over 8,000 funds, each representing an investment pool in which individuals or institutions can participate. At the end of 2003, there were more of these funds than there were common stocks on the New York or American Stock exchanges. Collectively, these 8,000 or so funds represented over $7.4 trillion dollars of assets, about 18 percent of the total financial assets of the U.S. population. At the start of 2004, 22 percent of U.S. retirement funds were invested in mutual funds.2

These funds give more than 90 million people the opportunity to participate in the securities markets without having to become money managers themselves. They are professionally managed, pooled investment vehicles. A mutual fund allows individuals (you, me, anyone with some money to invest) and institutions (corporations, foundations, pension funds) to pool smaller amounts of money into a larger amount for investment. Investment management professionals then manage this larger amount to allow

• investment strategies that would not otherwise be feasible (such as buying bonds that only sell in very large denominations);
• achieving economies of scale (such as paying low broker commissions) that are not attainable when investing smaller sums; and
• reduction of risk by holding a diversified basket of securities.

As we will see below, mutual funds offer the investor a number of significant advantages compared to investing in individual securities.

Because of these advantages, mutual funds have gained an increasing share of the nation’s financial assets. During 2003, mutual funds received 26 percent of households’ purchases of financial assets—that is, households put this money into mutual funds rather than bank savings, individual stocks, or other investments. These mutual funds purchases went into long-term funds. At the end of 2003, mutual funds reached their highest level of household financial assets at 18 percent, increasing from 10 percent ten years earlier. During these ten years, there was a securities markets boom in the late 1990s, and then a securities markets decline in 2001 and 2002. During 2003, the total assets invested in mutual funds grew from $6.4 to $7.4 trillion. The increase in mutual fund assets in 2003 rose from investment gains rather than cash flows because cash flows into long-term funds offset the cash flows from money market funds. Investment gains are dividends that shareholders reinvested in the funds, and the increase in value of the stocks, bonds, and other securities the funds held.

To a large extent, the mutual fund industry is an American phenomenon. While mutual funds or similar investment vehicles exist in other countries, they are nowhere so popular as in the United States, although in recent years more worldwide investors are using funds as their investment of choice. At the end of 2003, the U.S. assets invested in mutual funds represented 57 percent of the worldwide total of open-end, pooled investment funds of nearly $14 trillion. France has the next largest mutual fund industry after the United States, with funds holding the equivalent of more than $1.1 trillion assets. Although the U.S. industry continues to have outstanding growth, increasing assets 34 percent between 1999 and 2003, worldwide total net assets grew 49 percent during the same five years. During the ten years from 1994 to 2003, the U.S industry’s growth was 258 percent and the worldwide total net assets grew 236 percent.

The mutual fund industry is a significant component of the U.S. financial services sector and receives significant attention from the U.S Congress, federal regulators, and states who want to protect the interests of U.S. households and their retirement savings. At the end of 2003, approximately $2.7 trillion of retirement savings were invested in mutual funds, representing 22 percent of retirement assets—excluding social security benefits that Americans will need in the future to pay for their retirements. In 2003, it was estimated that the 8,000 funds generated over $80 billion in revenue and provided employment for over a quarter of a million people, with fund management companies, investment advisers, custodial banks, distributors, transfer agents, and other third-party service providers. Collectively, U.S. mutual funds owned about 22 percent of the equity of publicly held U.S. corporations, about 5.1 percent of the debt securities issued by the U.S. Treasury and various federal agencies, and about 18 percent of the bonds issued by municipalities (states, cities, and counties). In the past few years, authors have penned over 100 books advising investors how to use mutual funds to help them meet their financial goals. A number of universities have recently established courses in mutual fund management.

Mutual Fund Defined

Before going any further, a few definitions are needed. All the funds listed in the “Mutual Funds” section of the newspaper fall into one particular category: they are open-end funds. Open-end funds are ones that will always sell new shares to investors wanting to invest money, or redeem shares from investors wanting their money back, at a price dependent on the net asset value (NAV) of the fund. (Well, almost always—there are exceptions, which we will describe as we go along.) In addition, each fund in the paper is registered with the Securities and Exchange Commission (SEC) pursuant to the Securities Act of 1933, and, therefore, is available for sale to the public. By and large, when someone says “mutual fund” in the United States today, this is what he or she is talking about—a registered open-end investment company.

This book focuses on open-end funds. There are other types of funds and pooled investment vehicles, described briefly in the following paragraphs, but none approaches the stature of open-end funds in today’s economy.

Closed-end funds were more popular than open-end funds during the early years of the industry. Closed-end funds do not purchase and redeem shares at a price dependent on NAV. Instead, they collect a pool of money, issue shares once to the investors in exchange for their money, and normally plan to neither issue nor redeem these initial shares thereafter. The shares of a closed-end fund trade on the secondary market (such as the New York Stock Exchange), just as the common stock of a corporation does. The market determines the share price one gets when buying or selling the shares, and this price may be different from the net asset value.

Today, closed-end funds have declined in popularity (for reasons discussed in the next chapter), to the point that their assets in 2004 represented just over three percent of those of open-end funds. We will not focus on closed-end funds in this book, except on occasion to contrast them with open-end funds.

Unit investment trusts (UITs) resemble mutual funds, but the portfolio of securities of a UIT is fixed at inception and not actively managed. The sponsor of a UIT assembles a pool of money, purchases a basket of securities, and liquidates securities only in special cases (such as when a bond is called earlier than its maturity date). UITs are set up with a specified life span, after which they are liquidated, and many invest in debt securities. In general, holders of UIT shares purchase them to get a stable investment with a stated life span, although they usually can redeem their shares at any time at the current net asset value. At the end of 2003, Americans had UIT investments of less than $36 billion, a small fraction of the amount held in open end funds.

Variable annuities (VAs) are contracts sold by insurance companies, which are often backed up by mutual fund investments. The investor pays a lump sum or makes periodic payments; the insurance company invests this money in a portfolio of securities, often mutual funds. The value of this invested money goes up or down as the prices of the underlying securities rise or fall. After a specified period of time, often when the purchaser reaches retirement age, the insurer starts paying the investor an annuity. The amount of these annuity payments (or, the lump sum amount the contract holder may elect to take) varies according to the performance of the underlying securities.

The insurance contract allows the investor to defer the tax on the income earned from the investment until the money is withdrawn. This feature of VAs appeals to investors looking for ways to invest for retirement. On the other hand, variable annuities come with a cost—sales charges, administrative charges, and the mutual fund’s expenses, or the costs required to manage the underlying investments when a mutual fund is not the investment of choice. The magnitude of these costs varies from one contract to another and from one insurance company to another. As of the end of 2003, Americans had about $866 billion invested in VAs3 for which the underlying securities were mutual funds.

Hedge funds, another type of pooled vehicle, differ from mutual funds mainly because they are not aimed at the general public, but rather at the sophisticated and large investor. Hedge funds are pr...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Dedication
• Foreword
• Acknowledgments
• Chapter 1: Introduction to the Industry
• Chapter 2: A Brief History of Mutual Funds in the United States
• Chapter 3: Overview of Industry Structure
• Chapter 4: The Mutual Fund—Product Definition
• Chapter 5: The Investment Management Front Office
• Chapter 6: The Investment Management Back Office
• Chapter 7: Fund Accounting, Audit, Legal, and Other Support Functions
• Chapter 8: Fund Distribution: The Broker Channel
• Chapter 9: The Direct, Bank, and Institutional Channels
• Chapter 10: Cross-Channel Issues: Advertising and Retirement Investing
• Chapter 11: The Transfer Agent, Part 1—Shareholder Record Keeping
• Chapter 12: The Transfer Agent, Part 2—Customer Service
• Chapter 13: Other Service Providers
• Chapter 14: Going Abroad: Open-End Funds Outside the United States
• Chapter 15: Going Forward: Issues and Challenges
• Index