Despite the pall that has fallen over the mutual fund industry amid discoveries of market timing, late trading, disclosure of non-public fund information and inflated commissions to brokers, the industry actually has something to celebrate. The anniversary of the birth of the very first mutual fund will take place next month.
Eighty years ago, on July 15, 1924, MFS Investment Management of Boston launched the first mutual fund, Massachusetts Investors Trust, some 16 years before the birth of the Investment Company Act of 1940. Not surprisingly, the fund, which started as an adjunct to trust law and was created as an investment affiliate for law firms, was greeted with great skepticism, as was the later enacted 40 Act, which at the time was itself highly controversial.
Five years later, when that first mutual fund showed it could withstand the stock market crash of 1929 and then the Great Depression, the mutual fund concept garnered a whole new level of respect and caught on. By 1940, there were 68 different mutual funds available, and by 2002, that number had grown to more than 8,200 funds.
More than six decades ago, the 40 Act was considered highly restrictive, confirmed Bob Pozen, the recently installed non-executive chairman of MFS. Sixty-four years later, that strict regulatory theme has proven to have helped the industry, Pozen noted.
In hindsight, the root cause of the mutual fund industry's current problems is the explosion of the dot-com bubble, Pozen said. The industry's assets ballooned wildly from $1 trillion in 1990 to nearly $7 trillion by 2000. "When you grow that quickly, people get used to that growth," he said. Post-scandal, things will improve, he predicted. "You'll have a much more focused, thriving industry."
On its way to becoming an octogenarian, the industry has seen many milestones. Although no one in the industry is currently old enough to have witnessed that first fund debut, Money Management Executive asked some of the industry's pundits to tell us what they believe have been the most defining moments for the industry over the past several decades.
The Original Seismic Shift
Picking the greatest industry milestone is a piece of cake for John Bogle, founder and former chairman of The Vanguard Group of Malvern, Pa. But it wasn't necessarily the creation of the index fund, which Bogle is known for.
In the beginning, as the first mutual fund, Massachusetts Investors Trust was "organized, operated and managed, not by a separate management company with its own commercial interests, but by its own trustees," Bogle said. Compensation was based upon the income generated by the fund's investments, not the assets under management, he added. Years later, Vanguard would model its fund company in similar fashion.
But in 1969, following the lead of virtually every other mutual fund, Massachusetts Investors Trust's trustees asked shareholders for approval to demutualize and convert to an external management structure. That change of focus was the beginning of the end, as it caused the fund's fees to rise and performance to suffer, Bogle said. That seismic structural shift also set the groundwork for the transformation from management companies considering the interest of investors, to self-interest, Bogle added.
The industry suffered a further blow when the courts ruled that mutual fund management companies could become publicly held companies, he said. Now, seven of the top 50 mutual fund management companies are publicly held. "Thirty-six of those are owned by conglomerates, which poses a whole new layer of problems," he added.
Loads vs. No Loads
One of the biggest and best developments that took place within the mutual fund industry was the recognition by some investment management firms that no-load funds were a great product for a wide swath of the investing public, said Irving Straus, president of Straus Corporate Communications in New York. Early in the fund management industry's history, sales charges were the norm. Then a few pioneering groups, such as Scudder, T. Rowe Price and Vanguard took the revolutionary step of offering fund shares at net asset value, without a sales charge, he said.
"However, as great a bargain as this was, the investing public was led to believe that no-load' meant there was something missing in the fund's operation or management," Straus said. "In fact, in those early days, no-load was considered a four-letter word," he noted. But by the 1960s, no-load funds had enough of a following to fuel the creation of two no-load mutual fund trade associations. "Those no-load pioneers who put investor interests ahead of their own deserve an 80th birthday medal for sticking it out and winning against the ever-present counterattacks of the load fund industry," Straus said.
The tug of war between load funds and no-load funds continued within the industry for decades. A couple of decades ago, no-loads were the rage. But then along came a slew of load funds, and their alphabet soup of share classes was driven largely by the brokerage industry's distribution needs, said Lacy Herrmann, chairman of the Aquila Funds of New York, managed by Aquila Management. "Most funds rent a sales force," he conceded.
The war between the loads and no-loads is no longer relevant, said Burton J. Greenwald, president of consulting firm B.J. Greenwald Associates in Philadelphia. "I think the battle has been pretty well defined; is there an intermediary and does the investor use one?" he said.
Funds for the Masses
As strong as the legendary feud between the Hatfields and the McCoys, or loads and no-loads, the fight for fund turf was decidedly escalated by the creation of the mutual fund supermarket, said Steve Samson, CEO and co-founder of Alternative Investment Partners in White Plains, N.Y., manager of the Alpha Hedged Strategies Fund. "The introduction of mutual fund trading platforms has created unparalleled convenience for investors and a level playing field for no-load funds," he said.
Likewise, the growth of registered investment advisers (RIAs) as intermediaries for the mass affluent, from a cottage industry to a major market force, has proven to be a milestone for the industry, Samson said. RIAs now have access to the tools and technology that have afforded their growth as an intermediary force and allowed investors to enhance their asset allocation, he added.
Also notable was the introduction of the first money market fund, which, over a short period of time, won mass appeal among investors, Samson reminisced. While banks operated under legal limitations on the interest rate they could pay savings account holders, money market funds didn't have such restrictions and could offer often significantly higher market rates. That fueled billions and eventually trillions being tossed into money fund accounts, he noted.
Although the Depository Institutions Deregulation and Monetary Control Act of 1980 removed those limitations on bank savings accounts, allowing banks to offer higher rates and compete with money funds, "by then, hundreds of billions of dollars had been drained out of the banking system," Samson explained.
DC Revolution
Perhaps the most significant milestone for the industry has been the invention and proliferation of the defined contribution plan and the growing trend "of people taking care of themselves, into which mutual funds play such an important role," Herrmann of the Aquila Funds noted. Previously, people were used to having someone else, namely employers, saving money for them, he said.
While the bursting of the dot-com bubble was painful for many, the monumental changes in the mode of communication across the mutual fund industry was, in itself, a huge technological leap that should be celebrated, he said. "Communication for the industry has changed," he said. Twenty years ago, by comparison, the technology was very primitive. But extremely sophisticated telephone systems were developed, and then, people casually said, "I'll send you a fax." Now, e-mail communications via the Internet can go worldwide in just nanoseconds. "The whole communication change has made everything easier to work with," Herrmann added.
Back to the Future?
While the fund industry has, for years, struggled with getting investors to understand that a fund's historical performance is not the single most important factor to consider in selecting one, the current push for greater transparency of data and focus on fund fees and expense ratios has sensitized investors.
That trend is apt to increase investors' reliance on choosing a fund based upon its low expense ratio, relegating fund performance to the back seat, Greenwald predicted. But choosing a fund solely based upon low expenses is just as unwise as choosing a fund based solely upon its performance, he added.
More recently, the industry has experienced what will likely become another historical milestone, that being the decision of fund investors to stick it out despite the industry's turmoil. "The most amazing thing to me is that, in the wake of all of the abuses, allegations, charges and scandals, the public's appetite for mutual funds has not been affected," Greenwald marveled. "In aggregate, fund flows have been remarkable and indicate a strong underlying faith in the industry."
