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Capital Markets: Mutual Funds

Leslie Norton

One of the great success stories of the decade-long U.S. bull market was the mutual fund industry. The industry that grew up around great pools of money for middle class investors was stoked by twin pillars of the stock market's growth -- the hunger for profits, and the need of an aging population to build retirement savings. Thus, mutual fund coverage is rightly regarded not only as a subset of coverage of the retirement and pension industry, but also of capital market development in general.

A Brief Description of Mutual Funds in the Developing and Developed World

Mutual funds are private vehicles of diversified investments in which investors can buy shares. Some are closed-end funds, where the shares are traded on a stock exchange, and some are open-end funds, which can issue unlimited numbers of shares. They can invest in stocks, bonds, or cash, and frequently in all three-they can also own tax-sheltered securities, bank loans, and more exotic investments. Many are listed on the stock market (closed-end), but most report the value of their assets per share on a daily or regular basis, and investors can buy or sell (redeem) shares daily (open-end funds).

The most popular mutual funds in the developed world in recent years have been stock funds. They gave investors a stake in the stock market, and the stock market's strength throughout the 1990s rewarded them richly. Analysts generally attribute a great deal of the stock market's strength in the U.S. during the 1990s to the exploding demand for mutual funds. Meanwhile, investors reasoned that because mutual funds contained shares of dozens of companies, they were diversified and hence, protected investors from the risk of holding a single investment. Managed by professionals, mutual funds were also attractive to investors unwilling or unable to manage their own investments.

By the end of the 1990s, millions of Americans were invested in the stock market through mutual funds. At their peak, the two largest mutual funds in the U.S.-- Fidelity Magellan and the Vanguard S&P 500 index fund -- each had more than a $100 billion in assets. As of October 2002, the largest mutual fund in the U.S. was Pimco total return fund, which owns mainly government bonds but can also venture into low-rated corporate debt and non-U.S. paper.

The fund industry is gigantic by any measure. At the end of 2001, the U.S. mutual fund industry oversaw $6.975 trillion in assets-a nearly sixfold increase from $1.07 trillion in 1990. The figure today is dwarfed by the size of the U.S. economy but not by much-the U.S. gross domestic product in 2001 clocked in at $10.14 trillion. Looked at another way, every person in the U.S. had $24,473 tied up in mutual funds in 2001.

How does the U.S. mutual industry stack up to those of other developed countries? It's bigger and more developed. In France, mutual fund assets total $701 billion, or $11,881 per person. It's equivalent to 53.5% of the French economy. Germans have $193 billion stashed in mutual funds-just $2,354 per person, or 10% of Germany’s economy.

To a large degree, the appetite for mutual funds was created by changing demographics-aging American baby boomers were troubled by the notion that social security and standard company pensions wee inadequate to support post-retirement lifestyles. The appetite was fueled by changes in laws regulating pensions. Specifically, laws were enacted that allowed investors to direct their retirement savings into a choice of investments, rather than leaving it in the hands of pension directors.

That gave employees more choices, but also posed greater risks. As global stock markets began to collapse in the spring of 2000, the erosion of mutual fund values became a cause of chagrin, particularly because U.S. and British pensions are heavily invested in equities. After all, while bank deposits are frequently insured, mutual funds aren't.

The rivers of capital that course through the world are steered by two forces: what's known as the "sell side"-the banks and brokers that finance companies by selling their securities to the public-and what's known as the "buy side" or big institutions like mutual funds that consume the products created by the sell side. The agendas of both are radically different. But the two will be useful sources of information for any financial story.

The mutual fund industry is a nascent one in the developing world. So far, bank deposits in Asia still exceed the market capitalization of the region's stock markets, and far greater sums are invested in bond funds than in stock funds. Still, it's a market that many companies in the developed world are eyeing hungrily. After all, governments across Europe, Asia and Latin America are trying to attract capital by deregulating and developing their capital markets. Active and liquid domestic stock and bond markets, the thinking goes, will create confidence in domestic assets and lure foreign capital too.

More importantly, nations are eager to develop capital markets because investment drives economic growth. But investment requires savings to finance it. A healthy mutual fund industry-as a repository for some of a country's savings--has much to do with the nation's sustainable growth prospects.

China has been active in deregulating its markets to allow mutual funds. One of Hong Kong's biggest successes in supporting its stock market during the Asian currency crisis of 1997-1998 partly owes to a scheme in which the Hong Kong Monetary Authority bought stocks to prop up the market, and then sold the stocks to investors in the form of a mutual fund known as the Tracker Fund. China has closely watched the successful experience of the Tracker Fund, in large part because the government controls billions of dollars of state-owned enterprises it wishes to privatize.

The developing world's limited experience with mutual funds has been mixed. In 2001 for example, a major reason for the steep decline in the Indian equity market was the experience of Unit Trust of India, a government-owned entity that manages two-thirds of India's mutual fund assets. A large chunk of the money it manages was invested in Unit Trust's largest fund, called US-64, where millions of small investors parked their retirement savings. (For a valuable discussion of US-64's troubles and its effects on the Indian stock market, see Jon Thorn, "Parallel Universe," The Asian Wall Street Journal, 8/23/01).

Owing to years of mismanagement, with assets directed to questionable investments, the value of us-64 declined. Yet US-64 reported asset values that were unnaturally high, even as stock prices were sliding. As a result, a number of UTI officials were arrested or fraud. The scandal raised questions about the safety for domestic investors of owning mutual funds. As the scope of the scandal was revealed, domestic investors redeemed shares in droves, driving Indian stock prices lower. Foreigners asked whether the Indian equity market was sufficiently transparent. UTI eventually decided to suspend investors' ability to redeem shares of US-64 for several months, violating the principle that mutual fund investors ought to be able to redeem shares whenever they like.

UTI, recalls Jon Thorn, runs India Capital fund, a Hong Kong-based fund for wealthy investors that specializes in Indian equities, was "on borrowed time" since 1998, when the government first had to bail it out; in June of 2001, it appealed again to the government to avert default. Among other issues, India investigated whether UTI executives were recommending that funds buy worthless stocks. In September of 2002, India bailed out UTI again with $3 billion of taxpayer cash, largely to cover the deficit in US-64.

For small investors, the lessons to be learned include an important one that stocks always bear risk, and that prices will fluctuate wildly. Meanwhile, nations seeking to build mutual fund industries can stumble badly. To thrive, funds ought to be managed by professionals, not bureaucrats, whose interests are aligned with those of investors. Moreover, a healthy industry-one that can prosper and gain even greater credibility--requires a strong regulatory environment and clearer transparency rules.

In the U.S., controversies around mutual funds have sometimes focussed on questionable investments, high fees and sales charges, conflicts of interest between the fund and its other customers, and whether funds are investing in what they say they are.

A Few Basic Things to Watch For:

  • The market. In getting started covering mutual funds, it's worth contacting the local mutual fund association, which tracks fund flows, or the amount of money coming into or going out of mutual funds at any given time, and the banks, insurers, and other companies that offer mutual funds in that market. Such flows often provide a window into demand or lack thereof for a particular market. Some analysts also believe that the flows have predictive ability for the market's direction. Sometimes, the data is sufficiently detailed that you can see the appetite for particular types of investments, whether they be high-octane growth equities, or slower-growth, dividend paying stocks. The Investment Company Institute, the main U.S. fund association, tracks other fund associations globally. You can find them on
  • Holdings. What are funds invested in? Mutual funds must regularly report lists of their holdings, usually every six- or 12 months in the U.S. These are often carried on Bloomberg or other financial data companies. These are useful sources for market coverage, for when a company is involved in an acquisition for example, or other activity that moves the stock.
  • Comparisons. How does a fund stack up to its competitors? There are plenty of people that keep track of this information, including Morningstar and Micropal. They will compare not only how funds' performance diverges (which can be a gauge of manager skill), but also how fees stack up. High fees and sales charges erode returns.
  • Size. How big is the fund? In the U.S., excessive size has often prevented fund managers from taking sufficiently large bets on stocks. Performance has often suffered as a result. On the other hand, managers that take excessive bets subject their investors to excessive risk.
  • Personnel. How long has the manager been running the fund? What kind of experience or track record does she or he have? When a long-time fund manager leaves a fund, that's often a trigger to some investors to sell their fund shares. Does a fund manager own shares in the fund? Are his or her interests aligned with those of investors? Many fund managers serve several masters: A mutual fund, and other portfolios too. Does the fund get most of his attention, or the least? Also, are the directors independent? Do they look out for investor interests? Or do they condone lousy performance from the fund manager?
  • Some people to speak to: Apart from the usual suspects, you may want to speak to brokers who sell mutual funds; big investors and investment advisers who organize portfolios of mutual funds for individual investors; newsletter writers; and competitors to various funds.

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