Mutual Funds

Portfolio Structures, Analysis, Management, and Stewardship

John A. Haslem

• Publisher: Wiley
• Year: 2009
• Print ISBN: 9780470499092
• eBook ISBN: 9780470530917
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

An authoritative, must-read guide to making more informed decisions about mutual funds

Providing a balance of theory and application, this authoritative book will enable you to evaluate the various performance and risk attributes of mutual funds. It covers a broad range of topics, including understanding the advantages and disadvantages of mutual funds, evaluating stock/bond allocations within fund portfolios, assessing fund diversification risk, measuring fund returns and risk, and making fund buy/sell decisions.

While informative chapters combine clear summaries of existing research with practical guidelines for mutual fund analysis, step-by-step decision checklists guide you through the selection of various mutual funds.

• Puts the risks and rewards of mutual fund investing in perspective
• Skillfully examines how to select and evaluate the best mutual funds
• Outlines mutual fund service advantages and disadvantages
• Discusses the long- and short-term effectiveness of mutual funds

Covering major theoretical and management issues in mutual fund analysis and portfolio management, this book is an authoritative guide.

PART I

Mutual Funds: Nature, Regulation, and Costs

CHAPTER 1

The Nature of Mutual Funds

CONRAD S. CICCOTELLO, J.D., Ph.D.
Associate Professor and Director of Graduate Personal Financial Planning Programs, Georgia State University, Atlanta, Georgia

As a first-year doctoral student at the Pennsylvania State University in 1990, I wrote my investments seminar paper on the performance of a sample of open-end mutual funds. My professor indicated that the paper was methodologically sound but suggested to me that finance academics did not really care about mutual fund performance (or, for that matter, about mutual funds, in general). So he advised that I examine something else in future research. Academics often lag what is of interest in the “real world,” and I recall thinking that mutual funds were important, and likely to become more so over time. But as a doctoral student, one learns to do what one is told to do. So, I put down the mutual fund topic during the rest of my doctoral program, although my interest in funds never waned. Soon after entering the professorate in 1993, I restarted my formal research on mutual funds. That research continues to this day.

While I had suspicions in 1990 that mutual funds would become an interesting and important topic, I did not even come close to imagining then what has actually happened in the mutual fund universe over the nearly two decades since my first research effort as a doctoral student. At the time of my first study, there were a few hundred open-end mutual funds that held about $1 trillion total. Today, there are well over 10,000 funds holding about $10 trillion in wealth. A confluence of societal and corporate trends over this time, the biggest of which being the large-scale changeover from defined benefit to defined contribution retirement plans, has fueled the tremendous growth of assets held in open-end mutual funds.

There has also been explosive growth in academic research about mutual funds. Most of that research in finance examines fund performance issues, broadly addressing the question: Do mutual funds “beat the market”? More recently, there has been a growing stream of research on institutional and structural aspects of mutual fund services and providers (Sirri and Tufano, 1998). One might view this research as more oriented toward marketing, studying the intersection of the supply and demand for mutual funds as well as the growing segmentation of both sides of that fundamental equation. The broad growth in the demographics of individuals owning funds partly explains this research trend. Several decades ago, mutual fund ownership was concentrated among the affluent. Now funds are owned by a wide range of individuals across the income spectrum. Over the past two decades, open-end mutual funds have become the primary financial wealth accumulation vehicle in American society, especially for middle-market consumers and the “emerging affluent.” Understanding mutual funds has thus become critical for social well-being. Nowhere is this decision more evident than in the choice of funds for an individual’s retirement plan.

This chapter first provides an overview of the nature, structure, and services of open-end mutual funds. The goal of this chapter is to introduce the reader to the characteristics of the open-end fund as well as the competitive environment for investment products. This chapter also sets the stage for more detailed discussions of various aspects of mutual funds that are presented in subsequent chapters. This overview chapter highlights how the open-end fund is unique, and the advantages and disadvantages the product has for individual investors. The discussion focuses on the key attributes of open-end funds, with the individual investor’s perspective in mind. Upon moving to Chapter 2, the reader should have a sense for the relevant factors necessary for understanding the open-end fund product and ultimately how these factors compare to those in alternative investment vehicles.

ATTRIBUTES OF THE OPEN-END MUTUAL FUND

Board of Directors

Open-end mutual funds are pooled investment products where a large number of individual investors can each own a “slice” of the investment pie. Stepping back from that general description, it is first important to understand how mutual funds are controlled. Most mutual funds are corporations or trusts that are managed by a board of directors, which consists of both inside and outside members. Inside members are typically officers of the investment adviser that manages the funds’ assets while outsiders (independents) can come from various occupations and backgrounds (some are even college professors). The mutual fund board’s primary responsibility is to protect the interests of the fund’s shareholders, similar to the duty that a board of directors has in an operating company. One key task that the independent directors of a mutual fund board face is the negotiation of the investment advisory agreement, which takes place during the “15-c process” (named after a provision in the 1940 Investment Company Act [ICA]). Another key task of the independent directors is to approve and oversee the fund’s independent auditors.

The board also technically oversees the other service providers of the funds, such as the distributor (who performs or oversees the actual transactions in fund shares with investors), transfer agent (who keeps shareholder records), and custodian (who holds the inventory of the fund’s securities). Once the investment advisory agreement is signed, the investment management company typically manages the day-to-day aspects of the service providers above. As Gremillion (2005) states, a number of investment management companies perform some or even all of the distribution and transfer agent functions themselves while others outsource these functions. The inside members of the board, much like inside board members/officers of the corporation in an operating company, typically oversee the administrative service functions of the fund on a day-to-day basis.

The ICA requires that a mutual fund board have a majority of independent directors. In recent years, there have been proposals to strengthen the “independence” of mutual fund boards by requiring that three-quarters of all board members be independent and that the chairman of the board be independent. These governance proposals have been controversial, and are discussed in more detail in Chapter 2 in the context of current regulatory challenges.

Liquidity

Perhaps the most distinguishing attribute of the open-end mutual fund is its liquidity feature. In an open-end fund, the fund itself stands ready to buy and sell shares from investors at the fund’s net asset value (NAV) each day (the fund is “self-liquidating”). For purposes of introduction, the reader can assume that NAV equates to fair market value of a share of the fund. So investors can generally buy or sell (redeem) shares of the fund for its fair market value each day, with the fund itself taking the opposite side of the transaction. This daily self-liquidating feature of the open-end fund is unlike the liquidity mechanisms in the competing investment structures. For example, compare the open-end fund to the closed-end fund. Investors have the ability to purchase or liquidate fund shares in closed-end funds, but the mechanism for exchange is typically trading the shares of the fund with another investor. As such, trading in closed-end funds is similar to trading a stock on an exchange (such as the New York Stock Exchange). In fact, many closed-end funds are listed on an exchange and traded similarly to stocks. In closed-end vehicles, purchases by investors do not add to total assets in the fund, nor do redemptions reduce the total assets in the fund. Thus in a closed-end fund, trades would most often take place with another investor and not the fund itself, unless the fund was repurchasing its own shares or selling new shares in as in a secondary equity offer. These are usually rare events and not the day-to-day reality.

Why is this self-liquidating feature of the open-end fund such a big deal? Having the fund standing ready to buy or sell shares from investors each day as opposed to transacting shares in a marketplace sounds like a somewhat trivial distinction. This feature, however, has probably been the single most troublesome regulatory issue surrounding open-end mutual funds since their birth in the 1920s. There are several reasons for this, but one relates to computation of the sale price, the fund’s NAV, as mentioned earlier. Ciccotello et al. (2002) details the historical regulatory issues, which initially related to computation of the NAV so as to avoid allowing the purchase or sale of shares at a “stale price.” In the past decade, in particular, large advances in technology have allowed for rapid order submission as well as an increase in the submission of bundled orders (“omnibus accounts”) to funds. This has put a strain on the challenges present in calculating NAV so as to not provide those who trade an advantage in doing so (Edelen, 1999). Chapter 2 details some of the regulatory and operating issues associated with fund pricing and rapid trading.

Aside from technical issues with setting the correct NAV, the fund’s self-liquidating feature can also have significant performance implications. Stepping back and thinking about how open-end fund performance is comprised is illustrative. Suppose that a stock fund has $500 million in assets today, and tomorrow $500 million of cash inflows arrive at the fund. The portfolio manager’s job has just doubled in size, and the overall return of the fund is now a blend of the return on the existing assets and the return on the new assets. Presumably, these inflows start as cash equivalents (they are put into a money market type of account) and remain as such while the portfolio manager invests them into assets in the fund’s particular investment objective. This would be stocks if the fund were a stock fund, bonds if it were a bond fund, and so on. Now reverse the process, and consider a $1 billion fund today where investors request $500 million in redemptions tomorrow. In this case, the portfolio manager might be in position where she might have to sell securities (such as stocks if the fund is a stock fund) in the portfolio to meet redemptions. Since the manager might have to sell securities to meet redemptions, open-end funds tend to hold securities that themselves are liquid in that they can be sold quickly and for fair value. In contrast, closed-end funds can hold illiquid securities in the portfolio since investors seeking to sell typically have to trade with other investors instead of redeeming assets from the fund itself.

So an open-end fund manager must not only select securities but also manages the portfolio with an eye toward daily flow into and out of the fund (Greene and Ciccotello, 2006). This aspect of portfolio management is unique to the open-end fund vehicle. The reader might suspect that these fund flow examples were concocted to overstate the point, but that is not really so. In recent years, both investment professionals and academics have become increasingly concerned with the performance and regulatory implications of “flow” into and out of mutual funds. The ability to buy and sell shares from an open-end fund is defined by the fund’s prospectus. Some funds restrict trading either by limiting the number of trades an investor can make in a given period of time or by imposing a minimum length of time between trades. Other funds impose a redemption fee, which requires that a percentage of the sale (2 percent is typical) be returned to the fund for the privilege of trading. Allowing an investor to trade in excess of prospectus limits while enforcing those limits against other shareholders can violate the prospectus and lead to regulatory action. Such problems were at the core of the mutual fund market timing scandal that broke in September 2003 (Hulbert, 2003; Masters, 2003). Chapter 2 discusses in more detail the issues associated with violation of prospectus trading limits during the recent mutual fund market timing scandal.

More generally, the timing of inflows and outflows from open-end funds has been a hot topic for academic research over the past decade. As Edelen (1999) observes in his groundbreaking paper, flows into open-end funds can have a significant impact on performance. As Braverman, Kandel, and Wohl (2005) observe, investors tend to buy shares in open-end funds after stock market prices have increased in the sector (or asset class) where funds invest, and similarly, they tend to request redemptions after market prices have fallen in that sector. Thus, mutual fund investors tend to chase performance and often arrive “late to the party.” Arriving late in a mutual fund context means buying shares after asset prices have already risen (and are more inclined to fall) or vice versa. Behavioral arguments suggest that investors would tend to herd by following the crowd—buying into sectors that have done well.

Also consider the actual portfolio management challenges associated with flows into and out of the fund on a daily basis. While mutual fund portfolio managers do have some discretion about how quickly to invest or divest from the fund’s risky asset base of stocks (assuming a stock fund), poorly timed flows into funds can create a significant performance issue. Since the fund is a pooled investment vehicle with a self-liquidating feature, those investors who are not trading can be impacted by the trades of those investors who trade. Fund (in- and out-) flows have thus become a significant aspect both of the management of mutual funds, as just mentioned, and in the reporting of fund performance. Fund flows also set up a conflict between the interests of shareholders who might want to trade funds often and those who want to buy and hold funds. This regulatory issue surrounding trading and performance reporting is discussed in more depth in Chapter 2.

In the context of this overview chapter, the key takeaways are that liquidity in an open-end fund matters to fund management and performance.

All-Equity Capital Structure

Another attribute that distinguishes open-end funds from other pooled investment vehicles is that open-end funds have a very simple all-equity capital structure. Sections 12 and 18 of the ICA limit any type of borrowing and forbid the issuance of senior securities (bonds) by an open-end investment company (Gremillion, 2005, p. 22). Closed-end funds, by contrast, often rely on both debt and equity (common and preferred stock) capital. According to the 1940 ICA, a closed-end fund may have up to 33 percent of its assets financed with debt (leverage). This might seem like a manageable amount of leverage, but debt can create problems for closed-end funds, ...

Table of contents

• Title Page
• Copyright Page
• Dedication
• Introduction
• PART I - Mutual Funds: Nature, Regulation, and Costs
• PART II - The Realities and Analogies of Investing
• PART III - Fund Types and Comparative Performance, Efficient Markets, Asset ...
• PART IV - Mutual Funds at the Crossroads
• Index