EXECUTIVE
SUMMARY | 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 horsesmouth.com,
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.
CONSTANTLY IMPROVING
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, www.lipperweb.com
.
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, www.cerulli.com
.
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, www.psca.org/data/44th.html
.
| |
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.
FUND STRATEGIES
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.”
ANALYZING THE FUNDS
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, www.iconfunds.com/iconfunds.html
.
Vanguard Private
Equity, Valley
Forge, Pennsylvania,
www.vanguard.com
.
Lipper
Holdings-Based
Indices, Denver, www.lipperweb.com/usa/services/lis/main.shtml
.
Fact
Set, Greenwich,
Connecticut, www.factset.com
.
Frontier Analytics,
San Diego, www.online.sungard.com/frontier
.
Morningstar,
Chicago, www.morningstar.com
.
Thornburg Funds,
Santa Fe, New
Mexico, www.thornburginvestments.com
.
CSFB/Tremont Hedge
Index, New York
City, www.hedgeindex.com
.
Money
Management
Institute,
Washington, D.C., www.moneyinstitute.com
.
Investment Company
Institute,
Washington, D.C., www.ici.org
.
Overlap, Kansas
City, Missouri, www.overlap.com
.
| | |
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.
WHAT’S COMING NEXT?
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.
A BRIGHT FUTURE
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. |