Chapter 5. Why Do Investors Own Mutual Funds?

For most investors, the case for mutual funds rests on the perceived advantages they offer. People buy and own mutual funds to receive these advantages, which include the following:

• Convenience.

• Diversification.

• Professional management.

• Favorable costs.

The convenience of mutual funds is an important advantage. Very simply, they offer an easy means of pursuing investing goals. There are numerous types of mutual funds that can easily be bought and held. Paperwork requirements are minimal, and little knowledge is needed to become a mutual fund owner and gain access to the conveniences that these funds offer investors.

Investors have various goals when investing, such as capital appreciation or steady income. For example, an investor with a 30- or 40-year horizon to retirement might readily seek maximum capital gains. A number of mutual funds have this as their stated objective, and thus investors can reasonably assume that buying these funds allows them to pursue such an objective.

Other investors wish to take essentially no risk of principal, and therefore feel confident that buying a money market fund protects that principal (the NAV of a money market fund is set at $1 per share and does not change). They can also purchase mutual funds holding nothing but U.S. Treasury securities.

Insights

Many investors are well aware of the overall importance of asset allocation, which might be the single most important factor in determining investment success. Asset allocation is the process of allocating one's investment funds to major asset classes such as stocks, bonds, and cash equivalents. For example, many investors have portfolios consisting of 50 percent stocks and 50 percent bonds. Pension funds often hold a portfolio of 60 percent stocks and 40 percent bonds. After you make the asset allocation decision, a portfolio's results are heavily dependent on what happens to the asset classes in general. For example, if you invest 90 percent in stocks and 10 percent in bonds , your investing results depend mostly on what happens in the stock market.

Mutual funds provide an easy and convenient approach to asset allocation. First, investors need to determine the best asset allocation plan for themselves . There are a number of Web sites available that make this easy. For example, an asset allocation calculator can be found at www.smartmoney.com/mag. Using the tools as this site allows an investor to quickly determine how much money he or she should have in each asset class.

As an example of asset allocation, an investor might, on the basis of recommendations from his or her financial advisor or recommendations in the popular press, wish to construct a portfolio consisting of several different elements: 50 percent of the investor's funds are to be allocated to domestic stocks, 15 percent to long- term bonds, 15 percent to foreign equities, 10 percent to real estate, and 10 percent to safe assets (money market instruments). Such an investment strategy could be accomplished by owning five mutual funds, each of which pursues one of the investment objectives described.

Of course, additional decisions must be made. For example, for the 50 percent of funds going to domestic equities, should the investor choose a value fund, a growth fund, or a fund seeking growth and income? Regardless, it is clear that mutual funds offer investors great convenience when it comes to finding funds that meet their financial objectives.

Diversification is a second important reason for owning mutual funds. This is a long-standing, traditional reason known to most investors. Diversification is a fundamental law of portfolio management: Investing is risky because we cannot foresee the future, and the primary way to reduce this risk is to diversify. Almost all mutual funds by definition provide portfolio diversification, which investors with limited funds might have difficulty accomplishing by direct investing.

We already covered asset allocation, or the allocation of one's investment funds to different types of assets, such as stocks and bonds. Within each category of assets chosen , the investor needs to think about diversification. By diversifying correctly, investors, and mutual funds, are able to spread their risk among a number of securities.

Think about a mutual fund holding 150 or 200 stocks, one of which was Enron when it filed for bankruptcy. While holding Enron could produce a loss (if it was not sold in time), it would have only a small impact on such a well-diversified portfolio.

If an investor owns only one security in a portfolio, his or her entire wealth rises and falls on this one security. During the years when Cisco was one of the great growth stocks in U.S. history, Cisco constituted a great wealth-building strategy by itself. Why own a portfolio when you could compound money at the rate Cisco did for several years ?

The answer came in 2000 and 2001, when Cisco fell 80 percent in price. An investor whose entire wealth was invested in this one stock suffered a significant decline in the wealth that had been built. This investor violated the primary rule of portfolio management ”always diversify. Although such an investor would have built wealth for a period of time, the lack of diversification finally caught up, and the results were painful.

Many investors cannot adequately diversify on their own. It has traditionally been commonplace to say that somewhere between 10 and 20 properly chosen stocks provides all the diversification one needs, but more recent research suggests that for most investors the number is higher. You are better off using numbers like 30 to 40 stocks in deciding what constitutes adequate diversification.

Thus, if we think about round lots (e.g., 100 shares is a round lot) it quickly becomes obvious that it would take substantial funds to build a diversified portfolio of 30 or more stocks. In contrast, buying a diversified mutual fund provides instant diversification.

Under existing federal regulation, most mutual funds are classified as diversified, meaning that at least 75 percent of a diversified fund's assets must be invested as follows :

1. No more than five percent of assets can be invested in any single stock. ^[1]

   ^[1] If a position appreciates to more than the five percent limit, the excess need not be sold.

2. No more than 10 percent of the voting stock of any single company can be owned.

Most large equity mutual funds own dozens or hundreds of stocks, and therefore provide instant diversification. Risk is reduced relative to owing only one or a few stocks.

Mutual funds do offer a nondiversified alternative: If they do not follow the guidelines just given, they are classified as nondiversified. ^[2] In this case, they must follow these guidelines for at least 50 percent of their assets, and no more than 25 percent of a fund's assets can be invested in a single stock. Of course, this means that a nondiversified fund could invest 50 percent of portfolio assets in only two securities. The Janus Twenty Fund is an example of a nondiversified mutual fund ”it holds 30 or so stocks in an attempt to concentrate its bets. This worked spectacularly well in 1998 and 1999, but very badly in 2000 and 2001.

^[2] A fund's prospectus must tell investors if the fund is nondiversified.

Professional management is a third reason for owning mutual funds. Investors hope, and expect, that professional management will lead to performance superior to that of an index fund or passive portfolio. Investors are hiring professional managers who expect, and often promise, to outperform the market. If they can't offer such a prospect, why would investors buy a mutual fund unless it is an index fund?

Many investors ”indeed, most investors ”do not have the expertise to assemble and manage a portfolio of securities on an ongoing basis. For example, how many investors can effectively construct a portfolio of municipal bonds, foreign securities, or gold mining stocks? Many investors need portfolio managers to do the job for them, in the same way they need a mechanic to fix their car or a contractor to build a new room on their house.

Mutual funds are clearly selling their expertise to investors. You have only to look at advertisements for various funds to see that this is true. Funds are quick to tout a five-star rating from Morningstar and to point out if one or more of their funds have outperformed some market average for some recent period. In many respects, performance is the name of the game as investors try to determine and get on board with the funds expected to perform well in the future.

The cost issue is still another reason for owning mutual funds. The cost of investing might be lower than in the case of direct investing. Investors making their own investing decisions must pay transaction costs, and often pay hidden costs in terms of the bid “ask spread (the failure to obtain the best price when transacting). One of the important costs involved in direct investing is the time needed to do the job properly ”analyzing securities, reading annual reports and articles about securities, and so forth.

Mutual funds clearly have a variety of costs, and these must be paid by the fund's shareholders. Some in particular are not that inexpensive. Nevertheless, investors can, with reasonable efforts, find many mutual funds with very reasonable cost structures. In a later chapter we consider index funds, which have extremely low costs. Additionally, when you consider the savings in time and effort necessary to be your own portfolio manager, mutual funds can offer some real advantages.

The issue of costs arises in numerous contexts. One debate is whether investors generally would be better off buying bonds directly or through a mutual fund. Until recently, many would have argued that investors were better off using a bond fund because the purchase of bonds in relatively small amounts entailed significant transaction costs in the form of price concessions . New Web sites that make bond trading easier might alleviate some of this concern. Nevertheless, when one examines the cost of operating many of Vanguard's bond funds, it is difficult to argue that investors can do better, costwise, themselves.

Others argue that in today's world of much lower brokerage costs, brought about as a result of discount brokers and very aggressive competition, investors can do well on their own when it comes to costs. After all, a transaction can cost as little as $15, $12, or less.

It is certainly the case that brokerage costs have declined dramatically relative to the situation years ago. Nevertheless, it takes 30 or 40 stocks to really diversify well, so costs start to mount. Also, many investors do not transact at the most favorable price relative to a financial institution such as a mutual fund that performs such transactions every day. Many investors use only market orders rather than limit or stop orders. Although the differences in prices for a given transaction are typically very small, they add up as the number of transactions increases . In other words, an individual investor may get nicked 10 cents here and 5 cents there per share relative to a mutual fund, and at some point these costs make a difference.

In the final analysis, costs can make a big difference in the performance of funds over the long run. This is true even for equity funds. Recall that the average expense ratio for equity mutual funds in the United States is approximately 1.5 percent of assets annually. The funds must earn this much more than their benchmark simply to break even, before they start adding value for the shareholders.

Insights

Think carefully about the issue of costs for a minute. Assume you could build a portfolio of stocks that would return you 10 percent a year, every year, because this was the average rate of return on stock portfolios. Alternatively, you could buy a mutual fund that promises to do better than average because of the abilities of its staff and portfolio manager. It charges an annual expense ratio of 1.5 percent of assets. Clearly, this mutual fund must gross 11.5 percent a year to return a net of 10 percent a year, because the expenses have to be deducted. No problem, some would respond ”we can easily do that. However, in fact, this is not so easy to do, as we shall see.

Some equity funds charge less than the average, of course. For example, Fidelity's well-known Equity-Income Fund has an expense ratio of about 0.7 percent, or half the average. Likewise, other funds might charge more than the average.