Chapter 8. Mutual Funds Are Sold, Not Bought

We now turn to how investors buy their mutual fund shares and the pressures they face in doing so. If, as we consider later, mutual funds are not always the best alternative for investors in today's world, we need to ask ourselves how mutual fund ownership comes about in the first place and what pressures exist to get shares into investor hands.

There is also a second issue here. Investors are likely to be persuaded to purchase actively managed funds because many of these carry sales charges. Even if they do not ”meaning they are no-load funds ”the more assets the fund manager has to manage, the larger the total fees for doing so. Investors might be better off with index funds, but the incentives to sell them anything but index funds are large.

Fund companies responded to the strong demand for mutual funds in the 1990s. In 1990 there were a few more than 3,000 mutual funds. By the beginning of 2002 there were more than 8,300 mutual funds.

Figure 8-1 shows the rapid growth in the number of mutual funds for selected years since 1980. ^[1] In that year there were only a total of 564 mutual funds in the United States. By 1990 there were more than 3,000, and by 1994 there were more than 5,000. In 1996 the number of mutual funds exceeded 6,000, and by 1998 it had climbed to more than 7,000. In 2000 the number exceeded 8,000, and 2001 saw a very modest growth in the number of funds.

^[1] The source for Figure 8-1, constructed by the author, is the ICI Web site and various government publications , primarily Federal Reserve data.

Figure 8-1. The Number of Mutual Funds for Selected Years.

Do investors really need more than 8,300 mutual funds? Reasonable people can disagree , but it seems difficult to believe that so many funds are needed.

In a strong indication of the constant pitch by investment companies, the year 2001 saw an expansion of almost eight percent in the number of equity funds, according to ICI data. Meanwhile, the markets in 2001 were declining rapidly following a decline in 2000, and even total assets in stock funds were declining.

Companies that distribute mutual funds also developed new outlets to sell them. According to official ICI estimates, the share of new long- term sales made directly to retail investors decreased from 23 percent in 1990 to 16 percent in 2000. Meanwhile, the percentage made to retail investors through third parties or to institutional investors increased from 77 percent to 84 percent.

Many funds that are sold directly to investors are increasingly being marketed by third parties such as mutual fund supermarkets, fee-based advisors, and mutual fund wrap account programs. Therefore, investors could find themselves under pressure to buy a particular fund even when it is not in their best interests.

Insights

Mutual funds are sold, not bought. One of the old sayings in the mutual fund industry, this phrase remains true today, although perhaps not to the same extent. What does this mean? It refers to the practice of aggressively selling mutual fund shares to investors to earn the sales commission, which is derived from the sales charge on load funds. A number of years ago the average sales charge on mutual funds was 8.5 percent of the amount invested, a hefty fee indeed. Today, the maximum sales charge on equity funds charging a load fee is typically 5.75 percent.

Consider the incentives that are involved here. According to a knowledgeable estimate, brokers and financial advisors who make their money from commissions typically receive 80 percent of the sales charge (load fee) paid by investors when they purchase load funds. The remaining 20 percent goes to the fund company itself. This is a strong incentive for brokers and financial advisors to sell investors load funds. ^[2]

^[2] See Stephen Taub, "A Lukewarm Welcome," Mutual Funds , March 2002, p. 92.

Furthermore, brokerage firms have traditionally offered investors mutual funds managed by the firm itself. For example, Merrill Lynch, a major brokerage firm, offers investors mutual funds created and managed by Merrill Lynch. These funds carry sales charges and are an important source of revenue to the firm.

Brokerage firms have traditionally compensated brokers on the basis of commissions generated. They may provide incentives in the form of rewards (e.g., trips, resort stays, etc.) to the top producers . Mutual funds offer the broker a chance at a significant payoff. Brokers typically receive a larger share of the pie for selling in-house products, such as mutual funds offered by the firm.

One of the problems this raises is the objectivity of the advice given by the broker to the client. Is mutual fund ABC really the best fund for you, or simply one of many alternatives that rewards the broker more than others?

The same potential conflicts exist for financial planners who receive compensation on the basis of products purchased by their clients . Increasingly, with the sharp declines in the market in 2000 and 2001, individual investors are seeking help from people in the industry. In 2000, more than 80 percent of mutual fund flows came in through financial planners and brokerage firms, according to one estimate.

What about the role of mutual funds in the sale of their shares by brokerage firms? There is a practice in the industry known as revenue sharing that is now receiving some attention. This involves payments from the mutual funds to the brokerages over and above the sales load ”in effect, payments for having the brokerage firm offer a particular mutual fund company's shares to its clients. One recent estimate states that for the year 2000 the average large mutual fund company paid out about $60 million in such fees to each of its top distributors . ^[3]

^[3] See Richard Bierck, "The Fund Industry's Dirty Little Secret," Bloomberg Personal Finance , March 2002, p. 70.

Brokerage firms are naturally reluctant to discuss this issue, which is obviously very attractive for them. A majority of these payments go to seven large brokerage firms: Merrill Lynch, Morgan Stanley, Prudential, Salomon Smith Barney, UBS Paine Webber, A. G. Edwards, and Edward Jones. These fees do not come out of a fund's expenses, but rather out the mutual fund company's revenues .

The issue that such fees raise is one of objective advice for an investor. If your broker recommends a particular mutual fund for you, is it because it really is a good investment for you, given your circumstances, or because it is consistent with your interests, although not the best choice, and it is profitable for the broker to do so? Of course, we can envision a scenario whereby it is not all that consistent with your interests but is with the broker's interests.

With money management, the amount of assets under management is the name of the game. Funds, and ultimately fund employees , are compensated on the basis of assets under management because the funds charge a percentage of assets as the management fee. If assets under management decline, fees decline. More fund mergers are occurring, and more funds are being shut down. Smaller firms may have trouble surviving even if they are offering a good product to investors.

As noted before, most mutual fund flows are coming in through financial planners and brokerage firms. Because of these changes, some mutual fund companies feel pressure to change their offerings. T. Rowe Price is a well-known, highly respected mutual fund company that was always known for its no-load funds. In 2001 it introduced some load funds for the first time, which means that financial advisers can earn commissions by selling them.

Invesco, long a no-load mutual fund company with some highly regarded funds, announced that it will no longer sell its funds commission free. Investors must now go through brokers and other advisors.

To see the kind of incentives involved in managing mutual funds, consider the following example offered by John Bogle, a legend in the mutual fund industry who founded Vanguard and who has fought for the best interests of shareholders. ^[4] Bogle pioneered the first index fund more than 25 years ago, one of the great innovations in the mutual fund industry in terms of benefits to average investors.

^[4] This entire example is based on data from an article by John Bogle, and is another good example of the informative information on mutual funds supplied by Bogle in both his books and his articles. See John C. Bogle, "These Dogs Don't Bark," Bloomberg Personal Finance , March 2001, pp. 34 “37. Anything written by Bogle on mutual funds is highly recommended reading. He understands the issues like few people do.

It is important to understand here that money market funds charge much lower fees than do most other funds (their expenses are also much lower). A large staff is not required to run money market funds because most funds concentrate on the same short-term securities over and over. They purchase and hold Treasury bills, certificates of deposit, commercial paper, and so forth. Furthermore, money market funds are buying the same securities, and therefore there is little the typical fund can do to add much value.

Bogle cited a $61 billion group of money market funds being managed by a large financial conglomerate. For the year 2000, this group of funds paid $254 million in management fees, $64 million in distribution fees, and $71 million in shareholder service fees and operating costs, for a total of $389 million, or 0.62 percent of assets. Assume that the $64 million in distribution fees and the $71 million in shareholder service fees cover the services provided.

Bogle figured that $10 million might cover the direct and indirect costs of this operation. This means that the fund organization is left with $244 million ($254 “$10) in profit. Is it any wonder that fund companies like to run mutual funds, and that the name of the game is to sell shares and build asset bases?

A significant innovation in the marketing of mutual funds is the fund supermarket . Although this concept had been around for 10 years by 2001, it seems like a very recent development. Regardless, it has had a significant impact on the mutual fund industry.

Insights

A fund supermarket is simply a vehicle for allowing investors to choose from hundreds or thousands of mutual funds and hold them in one place, their brokerage account. It was started by Schwab as OneSource, which allowed investors to choose among funds with no transaction cost.

Investors have poured more and more money into the mutual fund supermarkets. In 1995, assets held in supermarkets totaled $78 billion. By the end of 2000 this total had grown to $377 billion.

Supermarkets clearly have their advantages, primarily convenience. A customer of Schwab or Fidelity can own different funds in one account, simplify record keeping, and keep up with all his or her transactions much easier.

Furthermore, the supermarket allows investors to purchase funds they probably could not own otherwise because of the funds' high initial investment requirement. For example, MAS Mid Cap Value has a $1 million minimum under normal conditions, but only a $2,500 minimum in the supermarket. On a smaller scale, assume you are interested in Weitz Value Fund, a no-load midcap value fund. The fund itself requires a minimum $25,000 initial investment, but using the Schwab supermarket approach, an investor can buy in for only $2,500.

A closer look at supermarkets reveals some other aspects that should be considered . First, much of the total assets in supermarkets are held in only two companies, Schwab's OneSource and Fidelity's FundsNetwork. Therefore, many shareholders are not participating in the fund supermarkets. A second consideration is costs. Generally, there is no free lunch . Funds participating in the OneSource program must pay Schwab an annual shelf fee of 0.35 percent of assets held through the supermarket. In turn, the funds might raise the fees they charge their shareholders.

According to one estimate based on Morningstar data, the typical fund in the OneSource program charges one quarter of a percentage more in the expense ratio than the average no-load fund not in this program. Of course, the funds in the supermarket program may outperform their counterparts not in the program enough to offset, or more than offset, this additional expense. Nevertheless, investors should be aware of this.