Reshaping the American financial system - Mutual Funds, part 1

New England Economic Review, July-August, 1997 by Peter Fortune

Since the mid 1980s the mutual fund industry has enjoyed explosive growth in the number of funds, the types of funds available, and total assets under management. Much of this growth is the result of the increasing convenience offered to owners of long-term assets. Mutual funds offer portfolio diversification and financial research unavailable to the individual investor. They do this in an economical way through economies of scale: And they provide liquidity not available to the owner of individual shares or debt instruments: The mutual fund shareholder can buy long-term assets upon which checks can be written, can pick up a phone to redeem shares at the end-of-day net asset value, and can costlessly exchange shares of one fund for those of another in the same family. It should come as no surprise that the proportion of equity and debt instruments held through mutual funds has risen relative to outright ownership.

Some fear that the long-term advantages of the mutual fund as an important innovation in portfolio management might carry a short-term price. One reads of rising concerns that mutual funds are not simply reorganizing the way we achieve our financial objectives, they are an integral part of, and possibly a cause of, the recent explosion in common stock prices - an explosion that might threaten to end in a market collapse, perhaps endangering the long economic recovery we have enjoyed since 1990. To the contrary, others conclude, the surge in mutual fund investments arises from investors' increasing enthusiasm for long-term assets, particularly equities. To the extent that mutual funds provide a low-cost and efficient way of shifting portfolios between cash, bonds, and equity, they are a part of the process but not a cause of exuberant market performance. After all, they invest in what we, the investors, want. What we have to fear, if anything, is not mutual funds themselves. It is the emerging attitude among investors that they do not want to be left behind in the scramble for capital gains and their belief that the recent low volatility of stock returns offers a chance for high returns at low risk.

This article is the first in a two-part study of issues surrounding mutual funds. The goal of this part is to provide an overview of the mutual fund industry. The first section outlines the defining characteristics of mutual funds, their regulation, and their taxation. The second discusses the costs to shareholders, both direct and indirect. The third section examines the growth of the industry, the liquidity of fund portfolios, and shareholder redemption behavior. The fourth section addresses some questions about the fragility of mutual funds in periods of financial stress. The article ends with a brief summary.

The second part of this study, scheduled for publication in a later issue of this Review, will focus on the question initiated in the third section of this article: What role might mutual funds play in the transmission of financial shocks? In particular, are they likely to be a stabilizing or a destabilizing force?

I. The Mutual Fund Industry

The Mutual Fund Concept

Mutual funds are investment companies organized to allow investors to participate in a portfolio of assets. Investment companies are organized into three broad groups: open-end investment companies, closed-end investment companies, and unit investment trusts. While closed-end investment companies are often called closed-end mutual funds, the term "mutual fund" is most commonly applied to the open-end company.

Closed-end investment companies, the modern remains of the British investment trust,(1) are structured like a standard corporation. They issue a fixed number of shares and invest the proceeds in an actively managed portfolio of financial assets. These shares are traded on registered exchanges or over the counter at prices determined by supply and demand, like any other corporation's shares. Closed-end fund shares are often priced at a discount or, less frequently, at a premium to the fund's net asset value per share (NAV). In contrast, open-end mutual funds, which also hold actively managed portfolios of financial assets, are obligated to buy or sell their shares at the fund's NAV. Any transactions in the open-end fund's shares are between the fund and its shareholders at prices linked firmly to the prices of the fund's underlying assets.(2)

A unit investment trust maintains its original portfolio, thereby forgoing the active management common to open-end and closed-end investment companies. Instead, asset changes are prompted primarily by maturity of financial instruments. In addition, unit trusts, like some closed-end funds, are designed to terminate at a specific time, at which time their assets are distributed among the shareholders. Like open-end funds, unit trusts must redeem shares at net asset value, but this redemption privilege need not extend to all outstanding shares. For example, shares in the S&P 500 Deposit Trust (called "Spiders"), traded on the American Stock Exchange (AMEX), can be redeemed only in large blocks of 50,000 shares; smaller blocks of shares are traded on the AMEX.