Topics Where Investors Need Better Grounding
One of the great advantages of mutual funds is that they make investing a simple matter for millions of people.
Or so you might think.
In reality, a lot of consumers probably don’t understand what they’re buying or how much they’re paying, several industry leaders admitted during a recent conference in Tucson. And the confusion is likely to get worse.
“So many of your shareholders are unsophisticated,” Gene A. Gohlke, an associate director of the Securities and Exchange Commission, told the 1,000 fund administrators and attorneys at the 1992 Mutual Funds and Investment Management Conference.
What’s more, fund companies and salespeople aren’t doing everything they can to educate investors, Gohlke said. In many cases, “it’s very difficult for investors to understand what they’re getting into,” he said.
Such criticism may come as a surprise to people familiar with the benefits of mutual funds, which include diversification, professional management, automatic record-keeping and wide investment selection--at a relatively low cost. The fund industry would not have enjoyed a tenfold increase in assets during the 1980s if people didn’t like what they were getting.
However, this very growth has led to an explosion of products and features, and more choices add up to more confusion. In particular, pricing arrangements, which govern the manner in which broker commissions are charged, are already complex and will become even more so, predicted Jon S. Fossel, head of Oppenheimer Management Corp., a New York fund group.
Another element in the confusion equation is that funds are being purchased by a wider--and presumably less sophisticated--group of investors. Fully 25% of the nation’s households owned at least one mutual fund as of year-end 1989, up from 6% a decade earlier, Fossel said.
What it boils down to is a greater potential for misunderstanding. Here are areas of prime concern cited by some of the conference speakers:
- 12b-1 fees. Before 1980, there were two basic ways to buy funds. You could seek the advice of a broker and pay him a one-time, upfront “load,” or commission, as high as 8.5%. Or you could bypass the middleman by investing in a fund run by a no-load outfit.
Today, broker commissions are increasingly likely to be generated in smaller increments through what’s known as a 12b-1 fee. A fund can charge no more than 1.25% annually in 12b-1 fees, but over several years this cumulative expense can exceed a one-time, 8.5% upfront load.
In addition, a broker might describe the fund as a no-load product. This isn’t entirely accurate because investors in a 12b-1 fund often must pay a back-end load if they withdraw money within the first few years after purchase.
Fully 37% of all funds charged 12b-1 fees as of year-end 1990, up from 9% in 1983, the year after 12b-1 fees were sanctioned, said Geoffrey H. Bobroff, senior vice president with Lipper Analytical Services, a Summit, N.J., research firm.
According to Gohlke, the SEC received more than 900 letters from disgruntled mutual fund investors last year. Though that’s not a large number given the widespread ownership of mutual funds, 29% of the complaints dealt with 12b-1 fees and related issues, he said.
“It’s no longer a simple choice between a no-load or an upfront load,” Gohlke said.
- Other commission arrangements. Another area of possible confusion is the development of separate classes of shares.
The most common division is between “A” and “B” shares, which give investors the following choice: Pay a one-time, upfront load, or pay an annual 12b-1 fee and possible back-end load if you sell shares within a few years. In either case, the actual investment--the fund itself--is the same.
Confused? It may get more complicated from here. Some companies are considering coming out with at least six classes of shares for a single fund, each with a different pricing arrangement, Bobroff said.
- The prospectus. This is the legal document that discloses key information on a fund. You might think of it as the owner’s manual--a pamphlet you can turn to if you have a question but not something you would want to read in a single sitting.
The problem with many prospectuses is that they’re filled with unappetizing legal jargon. Most are “too long, complex and incomprehensible,” charged Dudley H. Ladd, managing director of Scudder, Stevens & Clark, a New York fund family. One prospectus he cited contains a 243-word sentence.
“This shatters all canons of modern communications theory,” Ladd said, arguing that many college physics textbooks are more readable than the typical mutual fund prospectus.
- Money market funds. These low-risk investments have worked remarkably well since their inception in 1972, paying competitive yields without subjecting investors to losses. However, money funds aren’t federally insured and thus not fail-safe.
Some experts believe that it’s only a matter of time before a money fund sticks investors with a loss, although any damage probably wouldn’t amount to more than a few pennies on the dollar. Still, Fossel termed it a “misleading” promise to lull investors into believing that no money fund would ever break $1 a share, the level at which most are priced.
Too Many Choices?
Several new types of mutual funds have debuted recently, raising the question of whether investors are becoming confused by the many choices available to them. Here are some of the fund categories that have become popular within the last three to six years.
Adjustable-rate mortgage funds: Invest in short-term housing securities and other bond-like investments. The first one debuted in 1987.
Environmental funds: Invest in companies with products or services geared toward environmental cleanup. The first fund came out in 1989.
European funds: Invest exclusively in European companies. Most were launched after the big foreign stock rallies of 1985 and 1986.
Flexible portfolios: A broad category that includes value, total return and asset-allocation funds. Only three of 59 funds tracked by Lipper Analytical Services have 10-year records.
Health-biotechnology funds: Invest in health care and biotechnology stocks. Only two of the 10 funds are at least 10 years old.
Real estate funds: Invest in companies in the real estate industry, including real estate investment trusts (REITs). The first fund came out in 1986.
Short-term bond funds: Invest in low-volatility corporate and government bond funds coming due in one to three years. Only a handful of the more than 100 funds have 10-year records.
World-income funds: Invest in non-U.S. bonds, typically those issued by foreign governments. Proliferated after the big foreign bond rallies of the mid-1980s.
