Written for Public Mutual Berhad in June 2008
At US$12 trillion worth of assets under management as at end 2007, the United States is currently the world’s largest market for mutual funds, making up almost half of the total worldwide net assets of mutual funds of US$26.2 trillion.
According to data from the Investment Company Institute (ICI), the trade association of the American mutual fund industry, the US had 8,029 mutual funds by the end of 2007 with close to 299 million shareholder accounts.
There are more mutual funds in the US today than there are stocks on the New York Stock Exchange. The US mutual fund industry has come a long way since 1924 when three Boston executives pooled their money together and created the first modern mutual fund called the Massachusetts Investors Trust.
Still in operation today, the Massachusetts Investors Trust was successful from the beginning, growing almost eight times from an initial US$50,000 in assets to US$392,000 with around 200 shareholders, within the first year of its inception.
By 1929, there were 19 open-ended mutual funds and 700 closed-end funds. Then, that year the stock market crashed, causing the closed-end funds to lose their appeal while the open-ended mutual funds gained ground.
The abuses that led up to the 1929 crash, and the resulting Great Depression, encouraged the authorities to re-examine and tighten the regulatory climate. At this point, there was little in the way of federal regulation in the US securities and capital markets.
The Securities and Exchange Commission (SEC) was set up in 1934 to protect investors and maintain fair and orderly market practices. In order to protect consumer investments in mutual funds, all mutual funds now had to be registered with the SEC before investors could invest in them.
Several major legislations were also enacted, including the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Advisers Act of 1940 and the Investment Company Act of 1940.
These laws require that mutual funds have to meet certain specified operating standards. They also make it compulsory for funds to provide potential investors with a prospectus stating the fund’s investment objectives and policies, its management team, its fees and other information. Mutual funds are also constrained regarding what they are allowed to say in their advertisements.
The different legislations determine how a mutual fund is to be set up. According to the laws now in place, there has to be a custodian whose job it is to safeguard the fund’s assets. The custodian, usually a bank, makes and receives payments during securities transactions.
Another pillar in the mutual fund set-up is the transfer agent which may or may not be the same institution as the custodian. The job of the transfer agent is to handle all the back office requirements in administering shareholders’ account records – the transfer agent issues new shares, cancels redeemed shares, and distributes dividends and capital gains to the fund shareholders.
The third party, and the public face of the mutual fund, is the management company which is also the investment adviser that makes all the buy and sell decisions for the fund. They are usually paid a fee that is based on a percentage of the fund’s assets.
In 1940, with the legislation in place, there were 68 mutual funds in the US managing a total net asset value of US$450 million. This had increased to 361 funds in 1970 with total net assets of US$48 billion.
In 1976, John C. Bogle started the first retail index fund, called the First Index Investment Trust, after he discovered in his undergraduate thesis at Princeton that about three-quarters of mutual funds do not make any more money than if they invested in the largest 500 companies simultaneously. The First Index Investment Trust has been renamed the Vanguard 500 Index and in November 2000, became the largest mutual fund ever with US$100 billion in assets.
The mutual fund industry received a big boost in 1981 when the Individual Retirement Accounts (IRAs) were developed. These allowed individuals, including those in corporate pension plans, to contribute up to US$2,000 a year. Mutual funds are now a significant part of company retirement plans, such as 401k and 403b plans, as well as IRAs and Roth IRAs. Mutual fund assets held in IRAs were US$2.2 trillion as at end 2007, an increase of 13 per cent from the year before. They represent 47 per cent of total IRA assets of US$4.7 trillion.
Since 1980, when the mutual fund industry started to really take off, mutual fund fees and expenses have been heading south, with paid fees and expenses on equity funds declining by more than half, from an average of 2.32 per cent of fund assets in 1980 to 1.02 per cent in 2007, according to the ICI. Bond funds have also seen their fees and expenses fall by a similar amount.
This dramatic fall in fees and expenses can be attributed, in part, to the increasing economies of scale and the intense competition within the mutual fund industry, as well as to the steep drop in sales loads brought about by the growth of mutual fund sales through employer-sponsored retirement plans. Load funds often do not charge loads for purchases of fund shares through such retirement plans. No-load funds, sold through mutual fund supermarkets and discount brokers as well as the employer-sponsored retirement plan market, also grew in popularity.
Today the US mutual fund market is made up of several different types of funds. Stock funds are still the most popular with total net assets of US$6.2 trillion at the end of April this year. This is followed by taxable money market funds at US$2.9 trillion, taxable bond funds at US$1.4 trillion, hybrid funds at US$699 billion, tax-free money market funds at US$479 billion, and municipal bond funds at US$380 billion.
Investor demand for mutual funds increased significantly in 2007, with new net cash flow to all mutual funds at US$883 billion, up significantly from US$474 in 2006 and US$255 in 2005. This demand has been fuelled by investor desire to meet long-term financial objectives such as preparing for retirement.