Chapter 2. Direct versus Indirect Investing

Basically, households have three choices with regard to savings options:

1. Hold the liabilities of traditional intermediaries, such as banks, thrifts, and insurance companies. This means holding savings accounts, money market deposit accounts (MMDAs), and so forth.

2. Hold securities directly, such as stocks and bonds purchased directly through brokers and other intermediaries.

3. Hold securities indirectly, through mutual funds and pension funds.

Investors always have direct investing as an option, making their own buy and sell decisions, typically through a brokerage account. If you have enough money to invest, you could duplicate the last known portfolio holdings of any financial intermediary, such as a mutual fund. If you have the time and ability, you can make the ongoing decisions in terms of managing the portfolio. With direct investing, you make the decisions.

However, most investors lack the funds necessary to assemble a portfolio of 50 or 100 stocks, and many investors do not have adequate funds to immediately assemble what is generally agreed on in today's world as a well-diversified portfolio ”say 30 to 40 stocks. Furthermore, most investors do not have the time or expertise to manage a stock portfolio on an ongoing basis, making the necessary buy and sell decisions based on informed judgments .

A pronounced shift has occurred in these alternatives since World War II. Households have increasingly turned away from the direct holding of securities and of the liabilities of traditional intermediaries and toward indirect holdings of assets through pension funds and mutual funds. All we are talking about here is hiring a manager and an organization to do your investing for you. The investment company or pension fund owns a portfolio of securities, and thus the shareholders of the investment company or the beneficiaries of the pension fund indirectly own the portfolio of securities.

Insights

Many investors opt for indirect investing , which refers here to turning one's money over to a financial intermediary such as an investment company, which in turn owns and manages a portfolio of securities on behalf of its shareholders.

An investment company is a financial organization whose business it is to manage a portfolio of securities on behalf of its shareowners. Mutual funds, which are open -end investment companies, are the most prevalent form of investment company. ^[1] Closed-end companies are similar to mutual funds but have shares that are bought and sold on exchanges. Although closed-end companies have been around for many years , they are relatively few in number, and their total assets are only a small percentage of mutual fund assets. Therefore, this book focuses primarily on mutual funds.

^[1] Another form of investment company is the unit investment trust, which is an unmanaged portfolio of securities, typically bonds, with low expenses.

An investment company can be thought of as a pure intermediary: It does not do anything for you that you, in principle, could not do for yourself. After all, if you have enough funds, you can assemble a portfolio similar or even identical to that held by the investment company and manage it yourself.

Of course, because most people cannot afford to buy the number of stocks held by a diversified mutual fund, and do not have the time and expertise to manage the portfolio, an investment company can often do the job better than we can do it ourselves . We simply turn over the management of our money to someone else.

Think about other examples of indirect investing. Pension funds manage portfolios of securities on behalf of workers, both in the public sector and in the private sector. If we retire from service to the state of North Carolina, or as an Exxon employee, we probably expect to receive a monthly check from the respective pension fund provided by our employer. These days, many of us provide for our retirement through 401(k) plans, individual retirement accounts (IRAs), simplified employee pensions (SEPs), and so forth.

The decision of whether to invest directly or indirectly is an important one that all investors should consider carefully . Because each alternative has possible advantages and disadvantages, it is not necessarily easy to choose one over the other. Investors can be active investors by investing directly or passive investors by investing indirectly. Of course, they can do both at the same time, and many people do exactly that!

Because so many Americans invest indirectly through investment companies, primarily mutual funds, I provide a quick overview of mutual funds. In the next chapter, I review the details of how mutual funds actually work.

Insights

A mutual fund is an investment company that pools the money of various investors and buys and manages a diversified portfolio of securities. The investors, or shareholders, buy shares of the mutual fund, representing ownership in all of the fund's securities. Investors share in the success, or lack of success, of the mutual fund they buy in direct proportion to the amount of the mutual fund shares they own.

The fund manager's job is to manage a portfolio of securities based on a stated objective, making the buy and sell decisions. The fund company takes care of all the paperwork and details. The only decisions for investors are these:

1. Which funds to choose (there are many alternatives).

2. How much to invest in each fund one chooses to own, both initially and over time.

3. How to handle the distributions from the fund (reinvest in more shares or spend the money).

4. When to sell the shares and get out.

It is important to stress once again that a mutual fund does not, in principle, do anything for investors that they could not do for themselves in terms of building a portfolio and managing it. Investors who purchase shares of a particular portfolio managed by a mutual fund are purchasing an ownership interest in that portfolio of securities and are entitled to a pro data share of the dividends , interest, and capital gains generated.

Shareholders must also pay a pro data share of the company's expenses and its management fee, which will be deducted from the portfolio's earnings as it flows back to the shareholders.

Mutual funds serve us both as retirement vehicles, where taxes are deferred until the money is withdrawn, and as savings vehicles in taxable accounts:

• Taxable investing. You might decide to save for your children's college education several years from now by investing in a mutual fund. Because this is typically a taxable situation, you will have to pay taxes annually on the transactions generated by the fund. The fund will distribute income, capital gains, or both (or it may incur losses), and you will pay personal income taxes on these distributions at your marginal tax rate. Investors following this approach expect to earn more with their mutual funds than they could by investing in savings bonds, savings accounts, and certificates of deposit. You take more risk, and you expect to earn a higher return.

• Tax-deferred investing . You can have a 401(k), Keogh, IRA, Money Purchase Plan, or other retirement program invested in one or more mutual funds. In this case, taxes are deferred until the money is taken out. Therefore, you don't have to worry about annual accounting for the gains and losses or having to pay taxes each year because you have a tax-deferred account. Of course, the tax man will eventually catch up with you. When you start withdrawing money from the account, presumably sometime after you retire, you must pay taxes on the amounts withdrawn, subject to the various tax laws and regulations in effect at the time.

We often refer to a mutual fund company, such as Fidelity or Vanguard or Janus, as offering a family of funds (another term used by the industry is fund complex ). Fidelity Investments is the largest mutual fund company in the world, with more than $900 billion under management, in several hundred funds. Investors with Fidelity can find equity funds of all types, hybrid funds that invest in both bonds and stocks, and all types of bond funds, both taxable and nontaxable. The company also offers several money market funds.

It makes sense that if an investor has all of his or her funds within one fund family, both the costs and the record keeping will be simplified. It is then a relatively easy matter to switch out of one fund into one or more other funds within the same family with one phone call or Web transaction. Of course, there is nothing to prevent investors from owning funds at several different mutual fund companies.

Another mutual fund company familiar to many investors is Vanguard, which is actually a mutual company owned by its shareholders. Vanguard is well known for its index funds in particular, which have very low operating expenses. The Vanguard S&P 500 Index Trust is one of the two largest mutual funds in the United States. This fund seeks to match the performance of the S&P 500 Index, and its operating fee is extremely low.

We will have occasion to talk about Vanguard several times in this book for many reasons, including some of the lowest annual expense ratios available in the mutual fund business. Costs are important, and low costs benefit shareholders. A later section of this chapter explains how mutual fund companies operate , using Vanguard as one example.

I also mention John Bogle, formerly the CEO at Vanguard, who has become a well-known commentator and crusader for the rights of shareholders. Bogle often criticizes the industry for what he views as bad practices, such as high fees, high turnover , and the like.

Other well-known mutual funds companies include T. Rowe Price, Janus, Dreyfus, and Franklin Mutual, just to name a few. Daily newspapers typically carry a full listing of mutual funds, separated into families.

Mutual fund assets remain concentrated among fund complexes. The five largest fund organizations held 34 percent of the industry's assets at the end of 2000. The 25 largest fund complexes held almost three-fourths of the total industry assets at the end of 2000.

As you will see in later chapters, investors can purchase some mutual fund shares directly from the investment company itself. For example, if you are interested in the mutual funds offered by Fidelity and Vanguard, you can purchase shares from each of these companies using some combination of the Internet, mail, and wire transfers.

An alternative way to approach mutual funds is through a brokerage firm. Two discount brokerage firms in particular, Schwab and Fidelity, are now well known for offering a " supermarket " of funds. Schwab, for example, offers OneSource, where an investor can select from a large number of funds without paying a transaction cost. When the economy slows down and the volume of trading in individual securities decreases, fund operations become increasingly important to firms such as Schwab.

Of course, traditional brokers such as Merrill Lynch offer a variety of mutual funds, as do other full-service brokers. This is a lucrative source of income for both the firm and the individual brokers, and they can be expected to pursue mutual fund sales aggressively.

The bottom line is that investors have immediate and easy access to mutual funds from a variety of sources:

1. They can invest directly with the mutual fund company via phone, mail, and Internet. A large amount of information is readily available to help them decide which funds to choose. With this alternative, the burden is on the investor to determine which funds to own.

2. They can use brokers and financial advisors. The marketing of mutual funds is clearly a large factor in their great growth and acceptability by investors. As you will see, there are strong incentives for brokers and advisors to persuade investors to buy mutual funds through them.

We examine the marketing of funds in a later chapter.