Mutual Fund Investors:Divergent Profiles

Alan Palmiter & Ahmed TahaWake Law01 Oct 07

A pop quiz …

1. Mutual funds are primarily owned by:a. Individuals on their ownb. Individuals with retirement

accountsc. Institutional investors

2. Mutual funds mostly invest in:a. Stocksb. Bondsc. Notes (money market)

3. What have been annual returns (1926-2004):a. Small-cap stocksb. Large-cap stocks c. Corporate bondsd. Treasury bills

4. Warren Buffet predicts that annual US stock returns over the next 10 years will be:a. 6.5%b. 9.6%c. 12.3%d. 21.7%

5. Past performance of stock funds generally predicts future returns. a. Yesb. Noc. Only low-performing funds

6. Mutual fund investors say they pay attention more to fees than to performance.a. Trueb. False

7. As a mutual fund investor, you are entitled to:a. Prospectus (before you invest)b. Annual report (showing fund

performance)c. Statements (breakdown of

expenses / fees / trading costs)

8. Mutual funds only impose a sales charge at the time you invest. a. Trueb. False

9. Annual rate that average stock fund sells and replaces stock (turnover) in its portfolio:a. 6%b. 56%c. 90%d. 153%

10. What is a no-load fund? a. An unleveraged fundb. A fund without sales chargesc. A fund without trading costsd. A fund without withdrawal fees

11. Think about your own largest mutual fund. What is -- a. Your current balanceb. Fund’s investment objectivesc. Fund’s sales charges, expense

ratio, trading costs d. Fund’s performance last year

12. Consider your car/vehicle: a. Its make, model, yearb. Its cost, MSRP, total miles,

safety rating, gas efficiencyc. You get our point

US mutual fund market …

US Households(112 million)

Own mutual funds(55 million / 49%)

Retirement account54%

Broker79%

On own46%

Direct29%

IRAs48%

DC plans52%

Stocks 60%

Money Mkt 23%

Bonds 17%

Mutual funds ($11.3 T)

Demand-side

Fund Types

Supply-side mutual fund market …

Top 10 groups(38%)

Next 15 groups(35%)

Rest(27%)

Mutual fund market

Financial retirement market

MutualFunds(27%)

Asset classes(risk/return primer)

Asset Classes(1926-2004)

Average Return

Standard Deviation

Small Company Stocks 12.7% 33.1%

Large Company Stocks 10.4% 20.3%

Long-Term Corporate Bonds 5.4% 9.3%

Treasury Bills 3.7% 3.1%

Effect of investing $10,000 for 20 years …

12.7%

3.7%

$10,000 (invested over 20 years)

Small Company Stocks, $109,264

Large Company Stocks, $72,340

Long-Term Corporate Bonds, $28,629

$10,000Treasury Bills, $20,681

0

20,000

40,000

60,000

80,000

100,000

120,000

Mutual fund investor profiles(demand-side)

Industry profile

Information before purchasing Fund investors (outside retirement plans)

47%

52%

55%

57%

57%

58%

61%

69%

74%

0% 10% 20% 30% 40% 50% 60% 70% 80%

Tax consequences

Sales charge (if any)

Performance vs. index

Minimum investment

Types of securities

Net asset value

Fund risks

Historical performance

Fees / expenses

ICI Investor Preferences (2006)

Where investors turn Fund investors (outside retirement plans)

14%

20%

25%

30%

33%

34%

40%

46%

73%

0% 20% 40% 60% 80%

Fund telephone rep

Rating services

Fund literature

Fund reports

Media

Fund prospectus

Friends / family / associates

Fund company

Professional financial adviser

ICI Investor Preferences (2006)

“The 90 million fund shareholders’ demand for investment performance and services at a competitive level of fees and expenses continuously impacts mutual funds.”

Paul Schott StevensICI President

SEC portrait

William O. Douglas:”The investors’ advocate”

The number/types of funds has proliferated, increasing need for information to help investors compare and contrast alternatives.

SEC (Mar 29, 1995)

Investors will benefit from a uniform fee table and management’s discussion of fund performance

SEC (1983)

Many investors find prospectuses “unintelligible, tedious, and legalistic” … Investors need to be provided with clear and comprehensible information.

SEC (Feb 27, 1997)

Funds may resort to advertising techniques that create unrealistic investor expectations.

SEC (Mar 17, 2002)

Prospectus VFINX

• Disseminated– after investment / then once

annually– Including electronically / filed SEC

• Disclosure– Investment strategies – Risks (narrative)– Performance (1/5/10 years)– Expenses (sales charge, 12b-1

fees, mgmt fees)– Turnover rate

• Effect– Omissions in fund literature not

fraudulent, if info in prospectus

Fund comparer(SEC website / NASD)

Statement ofAdditional Information

• Not disseminated– Available to investors (incorporated

by ref into prospectus) / file SEC– No fraud liability if in SAI

• Disclosure– Fund organization – Investment policies / limitations– Management of fund– Proxy voting policies– Financial statements

• Can cover multiple funds

Only disclosureof trading costs(brokerage commissions)

Annual and semi-annual statements

• Disseminated– Send semi-annually to all investors – Available on SEC website

• Disclosure– Annually, MDFP (what’s affecting

performance, line graph comparison to relevant index)

– Financials (including expenses, turnover rate)

– List of portfolio holdings (now summary of significant holdings, chart of category breakdown)

Focus on performance,not expenses

Advertising

• Regulated– SEC Rule 482 – must state where

can get prospectus– NASD Rule 2210 – must file with

Advertising Reg Dept

• Disclosure– Can include performance data

(standardized format)– Info beyond prospectus

• Required disclaimer– “Consider investment objectives,

risks, charges, expenses”– “Past performance does not

guarantee future results”

No longer does info needto be from prospectus

“The Commission should not be the arbiter of the appropriate level of fund fees. Whether fund fees are too high or too low is a question that we believe must be answered by competition in the marketplace, not by government intervention.”

Arthur LevittSEC Chair (1993-2001)

SEC attention to ICI, academic research …

Topic

Comment letters

ICI comments

News stories

Non-academic research

ICI research

Academic research

Prospectus disclosure (1998) 78 3 19 1* 7 0

Fund profile disclosure (1998) 256 1 2 0 4 0

Advertising rules (2003) 29 0 2 0 1 0

Compliance programs (2003) 47 26 1 0 0 0

Portfolio manager (2004) 34 3 0 0 0 1**

2% fee for redemption (2005) 400 10 5 0 2 6***

SEC citations (footnotes / rulemaking releases)

* AARP survey of MF investors

** Textbook, Regulation of Investment Companies

*** Articles/studies on trading abuses (finance journals, SSRN)

“Academic” portrait

How many colors do you see?

Investors’ Behavior

• Chase Returns

• Ignore Expenses (but not Loads)

• Ignorant of Objectives and Holdings

• Inattentive to Risk

Behavior: • Investors chase hottest

funds

• Convex Flow-Return Relationship

Reality: Little evidence of returns

persistence: past returns generally don’t predict future returns

Investors’ Behavior

• Chase Returns

• Ignore Expenses (but not Loads)

• Ignorant of Objectives and Holdings

• Inattentive to Risk

Behavior: • Expense level generally

doesn’t affect fund choices

• More sensitive to loads

Reality:Annual expenses greatly

affect investors’ wealth

Value of $15,500

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

10 20 30 40

6%

7%

8%

YEAR

$336,730

$232,104

$159.429

AnnualReturn

Investors’ Behavior

• Chase Returns

• Ignore Expenses (but not Loads)

• Ignorant of Objectives and Holdings

• Inattentive to Risk

Behavior: Most investors are unaware

of their funds’ objectives or holdings

Implication: Mismatch between

investors’ objectives and funds’ objectives

Investors’ Behavior

• Chase Returns

• Ignore Expenses (but not Loads)

• Ignorant of Objectives and Holdings

• Inattentive to Risk

Behavior: Expense level generally

doesn’t affect fund choices

Implication: Mismatch between funds’

risk and investors’ risk tolerance

Modest proposals …

(1) Point of sale disclosure

(2) Post-purchase statements

Fund XYZ performance

Inv return Expenses/costs Net return

1-year 4.5% 2.1% 2.4%

5-years 7.6% 2.4% 5.2%

10-years 11.5% 1.9% 9.6%

20-years 8.9% 1.6% 7.3%

Comparison

Fund XYZ vs.

Asset Class

0.00% 5.00% 10.00% 15.00%

Fund

Asset class

Fund

Asset class

Fund

Asset class

Fund

Asset class1

-ye

ar5

-ye

ar

10

-

ye

ar

20

-

ye

ar

Your statement (Fund XYZ)

Beginning balance $10,000

Investments $ 2,000

Withdrawals $ --

Investment return $ 850 7.7%

Expenses

Sales charge $ 60 0.5%

Adm/advisory fees $ 140 1.3%

Trading costs $ 80 0.7%

TOTAL $ 280 2.5%

Net return $ 570 5.2%

Ending balance $12,570

66% - lower expenses 34% - higher expenses

Expenses (compare to other comparable funds)

2.5%XYZ

6.3%0.3%

Your fund has about average expenses, but 40% of other similar funds have lower expenses.

You could be saving up to 2.2% on fund expenses.

The end