Mutual Fund Operations: Types, Fees, Performance, and ETFs
Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2
Chapter 23 covers mutual funds, and it is packed. This is one of the longer chapters because mutual funds are such a big part of the financial system. There are more than 7,500 different mutual funds in the US with total assets of about $12 trillion. If you have a retirement account, you are almost certainly invested in one.
How Mutual Funds Work
A mutual fund is an investment company that sells shares and uses the money to manage a portfolio of securities. They are sometimes called open-end funds because they are always open to new investors. You can buy shares at any time, and you can sell (redeem) them back to the fund at any time.
The price per share is the net asset value (NAV). At the end of each day, the fund calculates the total market value of all securities it holds, adds any accrued interest or dividends, subtracts expenses, and divides by the number of shares outstanding. That is your share price.
Mutual funds generate returns for shareholders in three ways. First, dividends or coupon payments from the underlying securities get passed through. Second, capital gains from selling securities within the fund are distributed. Third, the NAV itself can appreciate if the holdings increase in value.
Companies like Fidelity, Vanguard, and American Funds offer families of many different funds so investors can switch between them easily. The three largest fund families collectively have more than $1.7 trillion in assets.
Regulation and Governance
Mutual funds must register with the SEC and provide a prospectus that discloses the fund’s objectives, risks, historical returns, fees, and portfolio manager information. If a fund distributes at least 90 percent of its taxable income to shareholders, the fund itself is exempt from taxes.
The governance situation is interesting and somewhat problematic. A mutual fund is usually run by an investment company whose owners are different from the fund’s shareholders. Some mutual fund managers invest their personal money in the investment company, not in the mutual funds they manage. That is a red flag. The investment company has an incentive to charge high fees because those fees are its revenue.
Each fund has a board of directors that is supposed to represent shareholders. The SEC requires a majority to be independent. But someone who retired from the company can qualify as “independent” just two years later. And board members of large fund families earn over $100,000 per year, which is not exactly an incentive to rock the boat.
Stock Mutual Fund Categories
The menu of stock funds is long:
Growth funds hold stocks of companies expected to grow faster than average. The focus is capital appreciation, not income.
Capital appreciation funds (aggressive growth funds) take more risk, holding stocks of unproven companies with high growth potential.
Growth and income funds mix growth stocks, high-dividend stocks, and some fixed-income bonds for investors who want both appreciation and stability.
International and global funds invest in foreign securities. International funds focus entirely on non-US stocks. Global funds include US stocks too. Returns are affected by both stock prices and currency movements. A strengthening foreign currency boosts returns for US investors. A weakening one hurts.
Specialty funds focus on specific sectors or characteristics. Energy funds, banking funds, tech funds, precious metals funds, socially conscious funds.
Index funds are designed to match the performance of a specific market index like the S&P 500. They have very low expenses because there is minimal active management. Most studies show that actively managed funds do not outperform index funds, especially after accounting for higher fees.
Multifund funds invest in a portfolio of other mutual funds. More diversification, but you pay two layers of management fees.
Bond Mutual Fund Categories
Bond funds are classified by maturity (which affects interest rate risk) and issuer type (which affects credit risk and taxes).
Income funds focus on bonds that provide regular coupon payments. Some hold only Treasuries (no credit risk), others hold corporate bonds (more risk, more return).
Tax-free funds hold municipal bonds. Useful for investors in high tax brackets.
High-yield (junk bond) funds hold bonds rated below investment grade. High returns but very sensitive to economic conditions.
International and global bond funds offer exposure to foreign bonds. These carry exchange rate risk on top of credit and interest rate risk.
Maturity classifications matter a lot. Intermediate-term funds hold bonds with 5 to 10 years until maturity. Long-term funds hold bonds with 15 to 30 years. Longer maturity means higher yields but more sensitivity to interest rate changes.
The Expense Problem
This is the section that should change how people think about investing.
Expenses are passed on to shareholders and include management compensation, research, record-keeping, and marketing. The expense ratio measures annual expenses per share divided by NAV. Most funds have an expense ratio between 0.6 and 1.5 percent. The average for actively managed funds is about 0.93 percent.
Madura walks through a powerful example. Take two funds that both earn 9.2 percent before expenses. One has a 3.2 percent expense ratio, giving shareholders a 6 percent return. The other has a 0.2 percent expense ratio, giving shareholders a 9 percent return.
After 5 years, the low-expense fund is worth about 20 percent more. After 10 years, 40 percent more. After 20 years, 87 percent more. Same underlying performance, dramatically different outcomes for investors. Expenses compound just like returns do, except they work against you.
Load Fees
Load funds charge a sales commission, typically 3 to 8.5 percent, when you invest. If you put in $10,000 and the load is 6 percent, only $9,400 actually gets invested. On day one, you are already down.
No-load funds skip the middleman. No sales charge.
Some funds have a back-end load (a withdrawal fee) that starts around 5 to 6 percent and declines each year you hold the fund.
12b-1 fees are annual charges that cover marketing or administrative expenses. Some funds use these fees to pay commissions to brokers who brought in investors. So what looks like a no-load fund might actually be paying broker commissions out of your returns.
Performance Research
Here is the part that makes the case for index funds. Most studies find that mutual funds do not outperform their benchmark indexes, especially after accounting for expenses. Funds with high expense ratios tend to perform worse. Even after adjusting for risk, mutual funds have, on average, failed to beat the market.
Advocates of market efficiency say this makes sense. If market prices already reflect available information, it is hard to consistently pick winners. Mutual funds are still useful for diversification and convenience, but paying high fees for active management usually does not add value.
Ratings based on past performance are popular but not particularly useful. A fund that performed well over the last three years will not necessarily do well over the next three. But fund families advertise their top-rated funds heavily to attract new money.
Money Market Funds
Money market mutual funds sell shares and invest the proceeds in short-term instruments like Treasury bills, commercial paper, and certificates of deposit. They let small investors participate in money market instruments they could not afford on their own. Most allow check-writing privileges.
There are general-purpose funds, government-only funds (which invest only in Treasury and federal agency securities), and tax-exempt funds (which invest in short-term municipal securities).
The income earned on money market funds changes over time as the short-term securities mature and are replaced. When market rates rise, money market funds become more attractive relative to traditional bank deposits.
Closed-End Funds and ETFs
The chapter also covers closed-end funds and exchange-traded funds (ETFs).
Closed-end funds issue a fixed number of shares at the start through an IPO. After that, shares trade on an exchange like stocks. The price can differ from the NAV, trading at a premium or discount depending on demand. This is different from open-end funds where you always buy and sell at NAV.
ETFs are designed to track an index and trade on exchanges like stocks. They combine the diversification of mutual funds with the real-time trading of stocks. ETFs can be bought and sold throughout the trading day, while mutual fund transactions only happen at the end-of-day NAV. ETFs typically have very low expense ratios because they are passively managed. Vanguard, iShares, and State Street are major ETF providers.
My Take
The single most important lesson from this chapter is about expenses. The difference between a 0.2 percent expense ratio and a 3.2 percent expense ratio is staggering over 20 years. Yet many investors pay high expenses without realizing the cost because it is deducted silently from their returns.
The governance section is quietly alarming. When fund managers invest their personal money in the investment company rather than in the funds they manage, it tells you where their incentives really lie. And board members earning six-figure compensation for oversight roles are not exactly motivated to challenge management.
The research on fund performance is clear. Most actively managed funds do not beat their benchmarks. Index funds and ETFs with low expenses are the better deal for most investors. This is not a controversial opinion among finance researchers. It is the consensus finding. Yet the active management industry keeps growing because marketing is powerful and people believe they can find the exception.
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