Mutual Funds: Confusion Mars the Boom

Carl McWade thought he was making a foolproof investment a year ago when he bought a mutual fund investing in bonds backed by the Government National Mortgage Assn. (Ginnie Mae). After all, McWade thought, the U.S. government was standing behind the bonds.

But his delight turned to anger seven months later when he cashed in the fund and discovered that he had lost about 5% of his original investment. Although the government protected investors against default on the bonds, it did not protect against rising interest rates cutting the bonds’--and the fund’s--value.

“I feel like I got burned,” McWade, a retired Seal Beach advertising executive, said. “The advertising led you to believe it was a pretty stable price.”

The confusion of McWade and thousands of investors like him illustrates that the unprecedented mutual fund boom of the past four years has not come without some mishaps and controversy.

Lured by the funds’ convenience and hoping to capitalize on their spectacular returns, investors plowed four times more money into stock, bond and income mutual funds last year than was put into them during the entire decade of the 1970s. (Money-market funds, which invest in short-term credit instruments, also are mutual funds but generally are treated separately from stock, bond and income mutual funds, which invest in longer-term securities. They deal mostly in short-term credit instruments.) Responding to this insatiable appetite, mutual fund companies are creating funds at the rate of one a day, and cranking out new services and products unheard of a decade ago.

But industry officials--although pleased with the rush of new fund investors--say that thousands of them harbor widespread confusion and misunderstanding about mutual funds. Survey after survey shows that investors are bewildered by the increased complexity and variety of funds and are often not aware of the risks of mutual fund investing. Many expect current high yields and returns to continue and could be disappointed if those profits turn to losses, as is highly possible.

Meanwhile, the industry boom--and its mad scramble to lure even more investors--has led to some excesses and questionable practices that, some critics say, could mar the generally positive reputation of mutual funds and invite increased government regulation.

While some marketing and sales pitches have improved in recent years, many fund companies still use misleading, questionable or overly zealous promotional tactics, critics charge. Many newly created funds are risky and have unproven track records, they add. Some fund companies also inflate yields through risky practices not readily apparent to investors. And many fund companies are excessively boosting fees and sales charges--raising profits at the expense of investors’ effective returns, critics contend.

“Are we creating investment expectations that can’t be fulfilled?” asked John C. Bogle, chairman of Vanguard Group, one of the nation’s largest fund groups, and a frequent critic of industry practices. “That is the fundamental question.”

The exaggerated promotion of some funds “is going to blow up in the face of the mutual fund industry,” said William E. Donoghue, publisher of Donoghue’s Moneyletter, a mutual fund newsletter based in Holliston, Mass.

Some Fear a Shakeout

Eventually, some experts fear, a shakeout in the fund industry could occur if the stock market dives sharply or if interest rates rise significantly, or both. All of the industry’s phenomenal growth of late has come while interest rates were declining and stock prices were rising. The industry’s recent growth has not yet been tested by bad times.

Some industry observers even fear a repeat of the collapse of the early 1970s, when growth-stock funds that had been heavily hyped in the go-go stock market of the 1960s lost much of their value during the severe bear market of 1973-74. The resulting investor disillusionment led to a prolonged slump in mutual fund sales that did not end until nearly 10 years later when the current bull market started in 1982.

“There is definitely potential for disaster,” said Michael D. Hirsch, chief investment officer at Republic National Bank in New York and manager of several portfolios of mutual funds. “So far, there’s just been disillusionment.”

“What goes up must come down,” said Norman G. Fosback, editor of the Mutual Fund Forecaster, a Fort Lauderdale, Fla., newsletter. “A lot of investors will be very unhappy about that but, unfortunately, it’s a fact of life.”

But while fears of a slump do exist, a repeat of the 1970s is highly unlikely, industry officials contend.

First, they say, far more funds exist today than 10 years ago, providing a catalogue-like range of investment choices and risk levels. Money-market funds, possibly the single most important new investment product in the last decade, did not even exist 15 years ago. The nearly 1,400 stock, bond and income funds available today--more than triple the number of a decade ago--range from risky ones that invest solely in stocks of a single industry or country, to conservative bond funds that invest in highly rated government securities.

Easy to Switch Funds

Second, fund companies have made it relatively easy to switch between funds. Many companies allow investors to transfer money from one fund to another in the same family simply with a toll-free telephone call. In many cases, such switching is offered without charge or for a minimal fee, usually less than $10 per switch.

Such switching was widespread last September, when a decline of about 120 points in the Dow Jones average of industrial stocks prompted the transfer of billions of dollars from stock mutual funds into money-market funds.

Third, many companies have set up elaborate systems to explain fund investing. Fidelity Investments, the nation’s supermarket of fund companies with more than 100 products, now has 1,500 employees answering 150,000 phone inquiries daily, 24 hours a day, seven days a week. Fidelity also is among a few companies offering walk-in centers to sell mutual funds directly to consumers.

Fourth, many investment conditions point to continued fund investing. Although mutual funds are underperforming major stock and bond indexes, they still produce better yields than many certificates of deposit, Treasury bills and other conservative investments. Also, pension funds and foreign investors are flush with cash and are bound to deposit some of those greenbacks in mutual funds. And tax shelters are less attractive under tax reform.

Still, however, future growth may be more moderate than last year, concedes Alfred P. Johnson, chief economist for the Investment Company Institute, a trade group representing fund firms. Sales totaled $215.7 billion in 1986, nearly double the 1985 figure. In January, when stock prices exploded, sales of some funds skyrocketed.

In their rush to attract new investors, many fund companies are turning out new lines as fast as they can, often hoping that those funds get hot and land on a list of top 10 performing mutual funds. Such a ranking can mean millions in new sales.

Specialized and Risky

Many of these new funds are increasingly specialized--and risky. Perhaps the best example of this specialization is the 35 industry-sector funds offered by Fidelity Investments, called Fidelity Select Portfolios. In these, managers buy stocks in a single industry sector, such as high technology. Fidelity is even letting investors “sell short” some of these funds. Short selling allows a profit from the declining price of an investment.

These funds, because of their risk, are not for the average conservative investor, warned Neal Litvack, marketing manager for Fidelity Select. In fact, while some scored impressively on lists of top-performing funds during the past year, most did rather poorly, according to Joe Mansueto, president of Chicago-based Morningstar Inc., which tracks mutual fund performance. Only six of the 35 Fidelity Select Portfolios outperformed the Standard & Poor’s 500, he said.

But new funds also are coming out that purport to reduce risk. Fund families such as Dreyfus and Oppenheimer are offering “hedge” funds that use futures, options and other strategies to minimize up and down swings. Vanguard Group and others offer index funds that invest in the securities included in such broad market indexes as the S&P; 500. Many companies offer “balanced” funds that invest in stocks and bonds. There are even funds that invest in other funds.

The largest area of growth by far has been bond funds, which buy fixed-income securities ranging from Treasury bills to Ginnie Mae securities to high-yield corporate “junk bonds.” Bond funds and income funds--which invest in stocks paying good dividends as well as bonds--outsell pure stock funds by a 3-to-1 margin. Investors are attracted to bond funds’ superior yields over certificates of deposit, Treasury bills and money-market funds, and do not want the risk and volatility of stock funds.

Unfortunately, recent surveys show that many people do not understand that the bonds in bond funds carry longer maturities--and thus are more susceptible to loss of value in case of rising interest rates--than the short-term bonds in money-market funds.

Only Some Protection

Recent research by the Investment Company Institute, for example, shows that many people incorrectly believe that government bond funds are safer than money-market funds. In fact, while the government does guarantee those bonds against default, it does not protect against a loss in the value of the bonds themselves.

“The fact is, many people buy mutual funds without really understanding what they’re buying,” said Marshall Front, president of the Stein Roe group. Some investors, he added, “are going to be nastily surprised when interest rates shoot back up and they redeem and find they have less than what they originally invested.”

Investors’ lack of experience also is evidenced by the fact that about two-thirds of all equity, bond and income fund sales--and more than three-fourths of bond fund sales--are through so-called load funds. These are sold by brokers, dealers and other financial advisers and carry a load--or sales charge--that can run as high as 8.5% of the total investment.

By contrast, during the industry’s slump in the 1970s, many funds cut or eliminated sales charges to spur sales. Sophisticated investors typically buy no-load funds directly from fund companies, forgoing stated sales charges and increasing their net returns.

With a cornucopia of funds to sell and investors as bewildered as ever, competition among firms has intensified, spurring a dramatic increase in marketing and sales costs. A study by Financial Programs, a mutual fund company based in Denver, shows that consumers tend to invest in funds whose names are familiar.

Thus, the largest fund companies, such as Fidelity, T. Rowe Price, Franklin and Vanguard, spend millions on advertising and promotion. Fidelity alone is said to spend more than $30 million on marketing costs.

Boosting Ad Budgets

To keep up, smaller companies are boosting their ad budgets, too. Financial Programs, for example, this year will spend more than $1 million to advertise its 19 no-load funds, compared to less than $150,000 four years ago, spokesman Don W. Clark said.

But investors often pay for these higher costs through higher loads and other fees. Many of the newly created funds in recent years are charging so-called low loads of between 3% and 4%.

Funds are also quietly adding hidden charges, such as contingent deferred sales charges, or “back-end” loads. Investors pay these when they sell the fund. In some cases, these charges run as high as 5% of the entire investment if the investor sells after holding the fund less than a year. The charges usually decline if the fund is held longer.

Management advisory fees and other expenses also are rising slightly. Some total more than 1.5% a year, which is taken out of investors’ profits. The rise is due partly to higher mailing, auditing and processing costs and to the growing appearance of new funds, which tend to charge higher fees, said A. Michael Lipper, president of Lipper Analytical Securities, which tracks mutual fund performance. But the larger size of individual funds should produce economies of scale that should on balance reduce expenses, rather than increase them, critics contend.

Perhaps the most controversial of the new hidden charges is the so-called 12b1 fee, named for a section of the federal law allowing it. The fee--charged annually for as long as an investor holds the fund--allows the company to use fund assets to pay for marketing and distribution expenses.

Virtually non-existent a few years ago, 12b1 fees are now common. Newsletter editor Fosback estimates that investors will pay $1 billion in 12b1 fees this year, compared to virtually nothing three years ago. While some fund companies charge less than 0.25% in annual 12b1 fees, others charge more than 1%.

This increased use of loads and other charges has been a boon for brokerage houses, who often earn more selling a mutual fund than by selling individual securities, because loads even as low as 3% are higher than commission rates on individual stocks and bonds. And brokerage houses defend the fees, saying that investors who need and want advice should pay for it.

Fees Called Too High

But critics, including newsletter editors and even some fund officials, contend that fees in many cases are higher than justified.

Critics also contend that the new fees are not readily apparent to investors, either in fund prospectuses, advertisements or daily newspaper listings.

“It’s very hard to look and see what the fees are,” Steve Love, a Torrance financial planner, said. He and other advisers complain that fee information often is spread throughout prospectuses and is couched in legal jargon.

The fund listings in newspapers, supplied by the National Assn. of Securities Dealers, allow funds with deferred sales charges and 12b1 charges to carry a designation of “NL,” which means “no initial load.” Keystone Group, for example, is given an NL designation on its funds but charges an annual 12b1 fee of 1.25% and a deferred sales charge of 4% in the first year, scaling down to zero in four years.

The Securities and Exchange Commission, which regulates mutual funds, expects to propose new rules in the next couple of months that will clarify the NL designation, said Kathryn B. McGrath, director of the agency’s division of investment management. The SEC also has a proposal pending that will require prospectuses to list fees and loads explicitly in one place near the front of the document.

Perhaps the biggest industry controversy centers on bond funds and their marketing and promotion. With investors eagerly seeking high yields, a slight advantage in advertised yield can result in huge sales.

So, to attract investors, many fund companies pick convenient periods when their funds did well, ignoring other times when they did not fare so well, critics say. Many funds also misleadingly include gains from rising bond prices in their yields. Or they advertise unusually high yields in big type, but display the fund’s higher risk or fees in smaller type.

“In our view, present-day advertising has gotten completely out of hand, and, in important part, represents the worst kind of hyperbole,” Vanguard Group Chairman Bogle wrote in a Dec. 22 letter to the SEC.

Excludes Key Elements

Too many funds, Bogle added, “are advertising past performance--yields and total returns--that they must know as a certainty cannot be sustained, and will not soon recur.” He added that “mutual fund advertising emphasizes the single element of return . . . to the virtual exclusion of the other two essential elements of investing: risk and cost.”

The SEC’s McGrath contends that advertising abuses have subsided somewhat in recent months, as interest rates have declined and as SEC and industry critics “have been kicking trash cans and hollering and yelling” at funds. “Many firms are making a genuine effort to clean up their problems,” she said.

To clean up the rest of the industry, the SEC and the Investment Company Institute have generally agreed on a standardized method for reporting of bond fund yields that will include only bona fide interest and dividend income and exclude capital gains.

And to provide a fuller picture of the risk of bond funds, the SEC proposed in September that any fund advertising current yield would also have to disclose total return over the five most recent calendar years. Total return in this case would include capital gains or losses from changing bond prices due to changing interest rates.

But the Investment Company Institute contends that this approach will be misleading, because total returns on bond funds have been extraordinary high in the past five years due to declining interest rates, Investment Company Institute attorney Matthew Fink said. A final SEC recommendation is expected this summer, McGrath said.

Many fund officials welcome greater standardization and regulation. “The industry’s enormous growth hasn’t been equaled by regulations,” said Howard Stein, chairman and chief executive of Dreyfus. “What we need is more supervision, not less.”

Ultimately, however, the long-term success of funds will depend on their actual performance. Lately, the results have been mixed.

Some Underperformance

While stock funds outperformed major market indexes in the late 1970s, they underperformed the indexes last year. The average equity mutual fund rose only 16% last year, while the S&P; 500 returned nearly 19% and the Dow Jones industrial average gained 27%, including reinvested dividends. Bond funds did even worse against comparable bond indexes.

Some industry experts wonder whether this lagging performance is part of a longer trend caused by the industry’s growth and potential volatility. Larger funds, they say, often have less flexibility to implement their strategies or invest in stocks of smaller companies.

And, if funds become overly invested in certain securities or markets, it increases their risk and susceptibility to market swings. Mutual funds own about 25% to 30% of all junk bonds, Vanguard chief Bogle said, which is cause for some concern.

But others, such as analyst Lipper, say that funds will not always underperform the indexes. And even if they do, such comparisons are unfair. Funds are always at a disadvantage because of their management fees and other charges, and because they cannot be fully invested at all times. Also, investors must be expected to pay for the funds’ convenience and expertise. And the key is not whether funds outperform the indexes, but whether they outperform other investments.