Although the rest of America may need a manufacturing revival, mutual fund manufacturing is not in need of help, as the business has been growing continuously for three decades. Because of the sheer number of funds and the amount of investment dollars they control, there is a very high probability that we are buying new positions and selling existing positions to one or more mutual fund companies.
Because mutual funds and their business partners, the investment companies that manage the bulk of the nation's defined benefit retirement plans, control as much as 80% of the supply of stocks and bonds available to the investing public, it is important for us to explore the business in a bit more detail. Just like a coach studies competitors to understand their strengths and weaknesses, we should study our own competition, the professional world of money management.
Details on mutual funds are available through multiple sources. We use the data provided by Morningstar Advisor Workstation, which includes statistics on 29,344 mutual funds. Because Morningstar provides so many details, along with an ability to easily slice and dice data, any number of academics, mathematicians or analysts after a few minutes of work may believe they have reached the state of statistical nirvana. We are not so inclined to data-mine, as our major need is to gain a little knowledge on the costs of managing the portfolios and the flow of funds into and between stocks, bonds and everything else.
I know you just can’t wait for us to delve into the details, but I wanted to first share with you a little history of the mutual fund business which has taken us from one fund to the 29,344 you can choose from today. The first mutual fund, Massachusetts Investors Trust, was established in 1924. In the same year, Paul Cabot, another Bostonian, created State Street Investment Company. It was Mr. Cabot whose operation of State Street established the profession of modern investment management as we know it today.
Prior to Cabot, the only “investment” suitable to be held in trust were bonds paying a fixed amount of interest. Once the bond was purchased it was held until maturity. There was no thought of managing a portfolio, and by that accord there was no need for a third party investment manager. Cabot changed this when he established State Street, which from its beginning invested in common stocks. This is how he described it: “When I started out in this business nobody believed in common stock, you know. People thought they were risky and exotic, unsuitable for a conservative investor. Bonds were the thing.”
It takes a special person to change the world, and Paul Cabot was one such special person. He had to market himself as an individual people could trust completely. He was a Harvard graduate, married with five children, and lived a very conservative and outwardly trustworthy life. It has been said that in his later years, whereas the typical investment management office was elaborate, Cabot's office was sparse, decorated with a bookcase, a few wooden chairs, an old desk, and a coat rack.
He managed his fund's money with the same approach. He only invested in companies he felt had trustworthy management. The quality of the firm came first. He said, “The most important quality is management that’s able and honest.” Combining this quality with common sense, the best research available at the time, and risk-avoidance, he gradually convinced others that investment management was a worthy profession and that managers should be able to charge for the services they rendered to the public.
Paul Cabot may have created the third party investment management business, but it is the courts and Congress that we can thank, or blame if you so choose, for the escalation in the manufacturing and distribution system of mutual funds.In 1958, the Ninth Circuit Court of Appeals ruled against the Securities and Exchange Commission (SEC) who had sued to block the sale of shares in Insurance Securities Incorporated (ISI). ISI was the investment adviser and principal underwriter of an investment company. It had sold its shares for 15 times book value in 1956. Our Federal watchdog, the SEC, felt strongly that the sale constituted “gross abuse of trust.” The sale at 15 times book value violated the SEC Act of 1940, as this excess price represented a payment for succession to the adviser’s fiduciary office.
You may or may not know that a Registered Investment Adviser who offers investment advice for a fee imposes a duty to act as a fiduciary in dealings with his or her clients. They must at all times place their client’s interest above their own in all matters. The SEC felt that the sale at 15 times book value rewarded the adviser at the expense of the adviser's clients.
The court agreed with this assessment, but believed that the value of the contracts ISI held between itself and its clients were the property of the management company. This ruling changed the incentives for investment management companies from one driven by earning a respectable return for its clients, to one in which managers could reap excess profits through entrepreneurial activities up and beyond those earned through fund management.
Three other occurrences in the 70’s had a material impact on the mutual fund industry. They were the elimination of fixed commission rates, the establishment of Individual Retirement Accounts (IRAs), and the Employee Retirement Income Security Act (ERISA).
It is easy to understand how the elimination of commission rates changed the industry. When all investors paid the same commission no matter which broker they used, brokers competed with superior research or service. The level of commissions charged was high enough that the profits were sufficient to support these activities. When they were no longer sufficient, the research efforts were directed towards larger investors, mutual funds and other institutions.
Individual Retirement Accounts (IRAs) were the perfect law for the mutual fund industry. Contrary to some politicians, most individuals do not desire to pay taxes. If a tax incentive is given to them and they are able to participate, they will. Given that the amount of tax deductible contributions were limited to a relatively small amount, and the mutual fund industry was able to fully invest these small amounts of money into the markets with little cost, millions of individuals became new fund investors.
ERISA is a federal law that sets minimum standards for pension plans in private industry. The rules cover both Defined Benefit Plans and Defined Contribution Plans. You know these by their common names, a pension plan and a 401K (ERISA does set standards for other plans that include welfare benefit plans). ERISA virtually guaranteed the future of professional investment management by giving the right to plan participants to sue for benefits and breaches of fiduciary duty. The law also required a level of minimum funding of plan assets to meet future pension payments for defined benefit plans. This requirement created a very real incentive for employers to close or freeze their pension plans in favor of 401Ks. As you know, a 401K is funded by the employee, and the employee takes full responsibility for investment results. With this switch to 401Ks and the need for an investment product that could handle small contributions, the mutual fund industry again found themselves with millions of new fund investors.
At first these changes had minimal impact, but all that changed with the equity bull market of the 80’s and 90’s, and with the thirty year bull market in bonds just now coming to an end. Huge profits were created for the investment companies, and with huge profits available for the taking, funds were created nonstop. At the beginning of the 1950’s, there were approximately 75 common stock mutual funds available for investing. During the last couple years of the 50’s and into the 60’s, 240 new equity funds were introduced. In the 70’s and 80’s, an additional 650 were created. The 1990’s brought more than 1600, and during the last decade and the first four years of the current decade, thousands more made their way into the complex.
At the same time, the number of financial advisers has grown exponentially. Today you can find a fund adviser at your bank, your insurance company, your credit union, your financial planner, and your broker. If you check the Financial Industry Regulatory Authority (FINRA) Broker Check site, you will find information for 4303 individual licensed or registered investment salespeople who are within a 25 mile radius of our office. It is the work these individuals, and the direct marketing of fund companies, that generate the flow of money into and out of mutual funds. Let’s look at these flows in 2013:
Understanding fund flows is important to us. Given that market prices, especially for very large and powerful companies that make up our own universe for investing, are pretty close to the underlying value of their businesses, opportunities to buy low are hard to find. If people are indifferent to pricing, which I feel most mutual fund investors are (since it is nearly impossible to calculate an intrinsic value of a mutual fund portfolio), a positive flow of funds represents an increase in demand on a limited supply and thus a higher price. The opposite is also true, in that a negative flow of funds may just create an opportunity to buy low. This could explain why we are having a difficult time finding undervalued businesses to purchase today. I’m not too worried about that, as opportunities will always come about for those of us who have a little patience and recognize that the price paid is the single most important driver of investment returns.
The 4,303 licensed or registered salespeople and their firms need to be paid. The payments can come in the form of commissions for the sale of a fund. They can come from the fee paid to a broker or investment adviser for the selection and monitoring of a portfolio of mutual funds, or through some other method of payment for services. We are not too concerned about the charges, but as we look at the underlying cost that each fund owner pays to the fund company for the management of the fund’s assets, it is important to remember that the advisory costs are in addition to the management fees. In many instances, these fund costs are not easily available for an investor to see, but they do affect your returns.
Let’s take a look at the expenses passed through to the fund shareholders for investment management and at the brokerage cost that a fund company pays for the buying and selling of the holdings in the fund. This is not available directly, so we just have to guess at the cost. Being that Jack Bogle, the founder of The Vanguard Group, has been studying the cost of mutual fund management for more than fifty years, we will use his suggestions to calculate these costs as 1% for 100% annual turnover of fund assets. Obviously, each individual fund has a unique cost for their fund management. What follows is the simple average.
Source: Morningstar Advisor Workstation 2.0 as of January 10, 2014
As you know, one of our primary objectives for all of our clients is helping you maintain the purchasing power of your savings. In order to accomplish this, we need to make some projections of the minimum return you will need to accomplish this goal. A simple way to calculate the minimum required rate of return is to add up the following. Go ahead and fill in the blanks... it will be enlightening and beneficial.
Future Rate of Inflation (We are suggesting 2%) __________
Taxes paid on returns (0% to 4% of the total portfolio
depending on your tax bracket) __________
Cost of Investment Management (Commissions & Fees) __________
Total (Minimum Rate of Return Required) __________
Of the three items we suggest in calculating your own minimum required rate of return, cost is the simplest to obtain and monitor. The others are variable and are subject to a lot of guess work when looking beyond the current year. With a return goal in place, it is much easier to manage your portfolio. Next month we will share with you our expected rates of return for common stocks, and what we would expect to earn from bonds and other interest paying alternatives over the next year and beyond.
Until next time,
Kendall J. Anderson, CFA
Kendall J. Anderson, CFA, Founder
Justin T. Anderson, President