Mutual Fund Strategies

A new century demands a new approach.


RUMORS OF THE DEATH OF MUTUAL FUNDS ARE GREATLY exaggerated. Funds have grown and adapted over their 80-year history and continue to meet investors’ needs for diversification and professional management. Better tools to analyze and select funds mean CPA/financial planners can make better use of them in client portfolios.

SEC-MANDATED AFTERTAX REPORTING RULES MEAN funds must report as a return what the investor actually takes home, not what the fund manager generates. This will make it easier for CPAs to compare funds because all will use the same reporting standards.

IN RESPONSE TO DEMAND, MOST MUTUAL FUNDS HAVE increased their industry and sector fund offerings in areas such as energy, financial services, health care or technology. Exchange-traded funds also are a popular alternative for clients concerned about the tax consequences of mutual fund investing. And mutual fund companies also are making more hedge funds and funds-of-funds available.

CPA/FINANCIAL PLANNERS HAVE A VARIETY OF analytical tools they can use to make mutual fund recommendations. These include software, Internet databases and other online research tools that make it easier to compare and contrast funds, determine risk and provide in-depth information on a prospective purchase.

FOR THE FUTURE, CONGRESS IS CONSIDERING legislation that would eliminate the need for mutual funds to distribute capital gains annually. Shareholders would instead pay taxes on gains when they redeem their shares. And the SEC has issued new regulations requiring accuracy in fund naming—a fund must invest 80% of its assets in its namesake.

CYNTHIA HARRINGTON, CFA, is a financial journalist with 20 years’ investment experience. She began her career as a stockbroker and ended it as the owner and chief investment officer of an asset management firm serving high-net-worth clients. Her work appears in a variety of financial publications. She is a contributing editor of Accounting Today and, a subscription Web site for financial advisers.

ver the last several years, headlines in the business press proclaimed the coming demise of the mutual fund industry. The fees were too high, flexibility too low and shareholders had too little control over the tax consequences in traditional open-ended mutual funds. Exchange-traded funds (ETFs), hedge funds and separate accounts (which give investors direct access to money managers) were sounding the death knell for the 80-year-old mutual fund industry. But to paraphrase Mark Twain upon reading his obituary, reports of their death have been greatly exaggerated.

Open-ended mutual funds still are around because they continue to serve investors’ needs for diversification and professional investment management. They are growing because they can adapt to demands for improved products and because of newer, more sophisticated analytical tools available to the CPA/financial planners who recommend these funds. The new tools not only give investors a chance at better long-term performance, they also provide CPAs with an edge in using this investment product. The bottom line? If mutual funds haven’t been part of your client’s past, they certainly will be part of their future. Here is a review of the new analytical tools that can help CPAs pick the best funds for their clients as well as an update on the new services that make traditional mutual funds more attractive.

As originally conceived, mutual funds had serious flaws, some of which are described above. The industry responded. Total shareholder costs on equity mutual funds declined 40% over the last two decades, funds now come in every size and flavor and management has worked diligently to reduce the annual bite for taxable investors by lowering portfolio turnover.

In addition to the efforts by fund management, CPAs are getting another boon in helping clients manage investment taxes. The SEC-mandated aftertax performance reporting will spread across the industry this year. CPAs will now be able to compare apples to apples because a fund is required to report as a return what the investor actually takes home after paying taxes, not what the fund manager generates. “The new aftertax reporting is a much more effective way to allocate assets,” says Carl Kunhardt, CFP of Quest Capital Management in Dallas. “There’s been too much public misinformation, and individual investors have been led to buy the highest performing funds but ended up with less return than a more conservative fund after taxes.”

Exchange-traded funds answer some tax and fee problems as well. With ETFs, investors don’t realize gains until they sell their shares. Fees for the indexed versions are now averaging under 20 basis points compared with 100 basis points on traditional open-ended funds.

Trend Watch
In 1960, investors placed $73 million in open-ended mutual funds. Assets had passed the $1 trillion mark by 1990.

Source: Lipper, a Reuters company, Denver, .

By 1995 the competition from exchange-traded funds (ETFs) and separate accounts had garnered $54 million and $93 billion, respectively. Assets in traditional open-ended funds had topped $2.4 trillion. By the end of 2001, ETFs had claimed $81 billion, separate accounts $319 billion. Traditional funds’ assets had ballooned to $6.2 trillion.

Source: Lipper; Cerulli Associates, Boston, .

Workers saving for their own retirement have driven the growth in mutual fund assets. Today the 43 million 401(k) participants invest 62% of these assets in mutual funds.

Source: Profit Sharing Council of America, Chicago, .

Most mutual fund companies have increased their offerings of industry and sector funds in areas such as energy, financial services, health care or technology to enable investors to focus on a particular area. For example, Fidelity gives investors access to 41 discrete industries. Some mutual fund companies also are responding to the exploding demand for the absolute return strategies of hedge funds and private equity funds that invest in pre-IPO equity and other nonpublic securities. Vanguard recently announced a deal under which Hamilton Lane will manage a fund-of-funds for Vanguard’s accredited clients. While private offerings of these popular new vehicles have minimum investments ranging from $500,000 to $10 million, mutual funds’ funds-of-funds offer investors access for as little as $50,000. The industry is, after all, set up to cater to smaller investors.

It’s the CPA’s job to put new investment products to work for their clients. Quest Capital uses sector funds to add incremental performance to the overall portfolio. Carl Kunhardt, who chairs the firm’s investment committee, makes predictions on sector movements. He expected and received higher returns from the communication and technology sector funds he used in 1998 and 1999. In 2000 and 2001 his planners added real estate mutual funds and REITs to client portfolios. “We use a strategic allocation concept with sector funds,” says Kunhardt. “Our target allocation to an asset class might be 7%, for example, but our range is 5% to 10%. Some of the unused cash goes to the sectors we think will outperform in the short term.”

Glenda D. Kemple, CPA, CFP, principal and co-founder of Quest Capital Management, lauds Kunhardt’s work in keeping her and the firm’s other planners up-to-date on changes and new trends in mutual fund analysis. She emphasizes that these improvements haven’t varied the firm’s central focus. “We use quality fund families, look for consistent performance, long manager tenure and to minimize style drift,” she adds.

For most CPA/financial planners, ETFs and separate accounts, where planners place money directly with asset managers, live side by side with mutual funds. Quest Capital uses mutual funds for clients in tax-free or tax-deferred accounts and for smaller clients. Benjamin Tobias, CPA, CFP, CIMA, of Tobias Financial Advisors in Ft. Lauderdale, Florida, is wildly enthusiastic about ETFs. From nothing just three years ago, Tobias now has 35% of client assets in ETFs. But there are instances in which he doesn’t use the new products. “I like ETFs for the asset classes like domestic large-cap stocks where active managers are less likely to outperform the indexes,” he says. “But I don’t use the less liquid ones like small-cap funds or REITs because of the risk of not being able to sell due to lack of demand.”

Tobias uses hedge funds to solve another problem. He’s concerned about the money his clients have invested in fixed income classes. “I’m worried about what’s going to happen when interest rates rise again. Those classes will lose value,” he says. To protect against this, Tobias has begun to replace the bond funds in his client’s portfolios, which may decline in value with hedge funds that move independently of markets or interest rates.

Instead of eliminating fixed income entirely, other planners move to individual issues of bonds in laddered portfolios or use similar strategies. Setting up a laddered portfolio involves buying a series of bonds with staggered maturities, such as splitting funds among bonds with one-, three- and five-year maturities. Some planners have discovered the Thornburg Funds, which follow a laddered strategy within the traditional mutual fund structure. According to Brian McMahon, president and chief investment officer for Santa Fe, New Mexico-based Thornburg Investment Management, the company has managed its list of funds the same way since it started in 1984. “Most bond fund managers are pretty much fixed-duration managers. Frankly, that appeals to a certain group of investors who want to trade the funds,” says McMahon.

Thornburg portfolio managers replace bonds only rarely. Most are bought and held until maturity. “We’re spreading our bets and we don’t want to make a bet interest rates are going up or down,” says McMahon. “It’s not going to hurt us too much if interest rates jump. But, of course, it didn’t help us much in the last few years when rates plummeted and other funds clocked capital gains in their total return numbers.”

CPA/financial planners have the opportunity to bring new strategies to mutual fund selection. They also have access to analytical tools not available to the average investor. Historical and up-to-date performance characteristics are the foundation for planners’ research. But few stop with one database, software program or source of information.

Both Kunhardt and Tobias start their search for the perfect funds for each client with Principia Pro, mutual fund database analyzer software (see resource list in exhibit 1, right). They then turn to Frontier Analytics for the next phase of their research. Frontier is software that looks at the setup of the overall portfolio including style analysis and portfolio optimization. But neither stops there. “We continue our work with Overlap, which analyzes each security a fund owns,” says Kunhardt. “Then we can see how two different mutual funds are similar or different in terms of what style they say they follow compared with the style of the stocks they actually own.”

Exhibit 1: Internet Resource List
Icon Funds, Greenwood Village, Colorado, .

Vanguard Private Equity, Valley Forge, Pennsylvania, .

Lipper Holdings-Based Indices, Denver, .

Fact Set, Greenwich, Connecticut, .

Frontier Analytics, San Diego, .

Morningstar, Chicago, .

Thornburg Funds, Santa Fe, New Mexico, .

CSFB/Tremont Hedge Index, New York City, .

Money Management Institute, Washington, D.C., .

Investment Company Institute, Washington, D.C., .

Overlap, Kansas City, Missouri, .

Tobias scours mutual fund industry news. He tells the story of a bond fund manager for one of his accounts: Something seemed to change with the portfolio decision-making process. An inquiry to the Investment Management Consultants Association, to which he belongs, revealed the difference. Virtually all the manager’s staff had left for another company. “Since the top manager was still in place, the change hadn’t registered with any reporting service,” says Tobias.

In addition to newly developed tools such as the portfolio software and holdings analyzer, old tools are being updated with new concepts. Some practitioners, for instance, are focusing on downside deviation as a measure of risk instead of standard deviation, which planners have used since the 1950s. Investors don’t mind when stocks go up, goes the new argument. They feel risk only when stocks go down. For some, the Sortino ratio (see exhibit 2, right), which measures a fund’s downside risk, has supplanted the Sharpe ratio, which measures volatility up and down.
Exhibit 2: Risk Measures
Measure Definition
Standard deviation Volatility
Sharpe ratio Risk-adjusted return
Sortino ratio Return vs. downside risk
Downside deviation Volatility below target return

These new concepts have made their way into a familiar tool, the Morningstar Ratings, commonly known as the “stars” (see exhibit 3, below). The new stars give greater weight to what really matters to investors—downside movements in the price of their stocks or funds. The fund rating service also pulls ahead on the use of minimum acceptable return as the discounting factor instead of the risk-free rate. Recent research suggests very few investors are satisfied with earning the risk-free rate. The rate of return an individual wants is known as the minimum acceptable return. Morningstar also bowed to trends for more specific comparisons by breaking funds into 50 smaller, more industry-specific categories instead of four broad groups.

The Internet opens up new research possibilities as well. Tobias pulls up white papers and uses search engines to discover information about managers he’s considering using that may not be in their current biographies. Quest Capital’s Kemple calls the Internet a curse and a blessing. “Because so much information about mutual funds is available, the information becomes a commodity,” she says.

But Quest uses the Internet to service client accounts, which saves both money and time. They access up-to-the-minute client statements through a Web connection with their broker-dealer. Now, instead of paying overnight delivery charges on a five-pound package of mutual fund information, they e-mail the URL for the online document directly to the client.

Exhibit 3: Morningstar’s Stars Get More Specific
New Old
50 Morningstar categories. Four broad categories.
Over 3, 5 and 10 years. Same.
Multishare funds reported once. Multishare funds reported separately.
Greater weighting of downside risk. Standard deviation as risk.
Discounted by minimum acceptable return. Discounted to risk-free rate.

More client service support likely will be available over the Internet in the future. One current Web-based entry is Morningstar’s Adviser Workstation. It delivers data and analytical tools to CPA/financial planners in real time. For $5,000 per year per user, planners can access the full complement of Morningstar’s mutual fund data as well as tools to analyze a client’s fund holdings for style analysis and sector weights. The goal-planning module runs asset allocation tools on both current and projected portfolios.

The mutual fund industry is not standing still. Mutual fund investors benefited from increased contribution limits to retirement plans and greater tax breaks in IRC section 529 college savings plans. Two items on this year’s agenda for mutual fund lobbyists—a change in fund taxation and restrictions on market timers—could drive more assets to traditional funds.

The proposed change in taxation of open-ended funds has the greatest potential impact. Congress is considering a bill to eliminate the need for mutual funds to distribute capital gains annually. Under the new proposal fund shareholders would pay taxes on the gains once they redeemed their shares. This legislation would not come without a cost—households pay taxes on annual mutual fund capital gains distributions in the range of $100 billion. But the change would dramatically reduce problems for investors. “If the law changes so investors pay taxes when they redeem shares, it will make mutual funds more attractive to more investors,” says Kunhardt. “There’s much greater diversification in a mutual fund with 90 stocks vs. only 30 in the average separate account.”

Another problem for mutual funds is the need to keep cash on hand to satisfy redemptions. Since the returns on cash are low, especially now, this liquidity need provides a drag on overall fund performance. Mutual funds are seeking even more restrictions on market timers. The funds want to be able to impose additional limits on exchange privileges between funds to discourage “hot” money from buying their shares.

The SEC’s requirements for accuracy in fund naming will make it easier for CPAs and investors to classify a fund’s style. The new regulations demand that a fund invest at least 80% of its assets in its namesake. “If they call themselves a ‘health and biotech’ fund, then under the new rules 80% of assets has to be in those two industries,” says Andrew Clark, senior research analyst at Lipper in Denver. “At Lipper we will follow those SEC guidelines when assigning style.”

Clark concedes that once funds start strictly adhering to their named style, it will take an edge away from data reporting services and other tools that previously helped planners divine a fund’s style no matter what name the sponsor gave it. Since planners will no longer need help determining a fund’s style, Clark says “independent data sources will now add value with finer granularity. For instance, planners will need their help to show clients in which health and biotech funds they should place their assets.”

More important, Clark sees great significance in the fact the SEC mandates that holdings match the fund name, not other style indicators. He believes this is part of a growing trend toward holdings-based analysis over returns-based analysis. “In the last 35 years, portfolio theory has been based purely on returns. The tools—Sharpe ratio, alpha, beta—all incorporate some element of performance return,” he says. The Sharpe ratio is the popular comparison of a fund’s return vs. its risk; alpha is the measure of a manager’s ability to outperform an index or peer group; beta is the relative volatility of a fund vs. an index.

Clark reports that in the last five years there has been an increasing preference for attribution analysis to determine where alpha was generated. Lipper developed tools called Holding Based Indices that are now offered through FactSet, the supplier of market data to asset managers. They generate a model portfolio from their database based on the holdings in each asset class. This is the “average fund” in a class. Planners can use the index to compare a fund they may be thinking of recommending. “This index allows the planner to see the ‘tilt,’ or where the extra value came from,” says Clark. “It shows how much of the return was due to stock selection and how much was due to style.”

Clark also predicts vastly improved measures of risk in the future. “Risk isn’t that well managed using only standard deviation. We’re finding that skewness and kurtosis have affected long-term returns as well,” Clark points out. The statistical terms skewness and kurtosis refer, respectively, to the distributions of returns and the degree of variation from a normal distribution.

With new tools and greater flexibility, mutual funds will become more attractive for their clients. Investors get lower costs and lower taxes. CPA/financial planners get better tools that again give them an edge even when recommending the freely available open-ended funds. The result should be happier clients and more successful planners. Notice of the death of mutual funds indeed seems premature.


How the election may affect taxation of business income

This report summarizes recent proposals to reform the U.S. business income tax system and considers the path to enactment of any such legislation.


How to Excel pivot a general ledger

The general ledger is a vast historical data archive of your company's financial activities, including revenue, expenses, adjustments, and account balances. J. Carlton Collins, CPA, shows how to prepare data for, and mine data with, PivotTables.


Did you follow 2016’s biggest accounting news?

CPAs will remember 2016 as a year of new standards and new faces. How well did you follow the biggest accounting events? The 7 questions in this quiz will help you find out