Mutual Fund Hybrids Could Shake Things Up
Mutual fund buyers may have to learn to pick more than just investment style when shopping for funds. Like bank CDs, funds may soon come with three-, six- or 12-month terms.
The Securities and Exchange Commission on Tuesday formally proposed allowing investment companies to create hybrid mutual funds that could change the face of this giant industry.
Taken to one extreme, the proposal could be viewed as a bulldozer plowing down walls that now protect many individuals from wandering into the quicksand of high-risk securities: By permitting funds to require that investors stay in a fund for a minimum time period, one of the SEC’s aims is to make it easier for funds to own little-known securities that are tough to trade.
And those typically are stocks or bonds issued by smaller, more speculative companies.
Providing such small businesses easier access to capital has been one of the principal--and most controversial--goals of SEC chief Richard Breeden, as well as that of his boss, President Bush.
In practice, the SEC proposal won’t mean that the nation’s biggest mutual funds will suddenly come with early-withdrawal penalties. Most funds will stay exactly as they are.
What you’ll eventually see, however, is a crop of new funds aimed at the long-term investor. Indeed, most intriguing about the SEC’s idea is that it represents a federally engineered attempt to goose individuals down the path of long-term investing--at a time when many people still cling to their 3%-yielding money funds.
The SEC would create two principal types of hybrid funds:
* An “interval” fund, which would allow investors to take money out only on dates fixed in advance--say, quarterly or annually.
* A “pay-back delay” fund, which would always accept investor redemption requests but would also allow fund managers to honor those requests over time rather than all at once.
Currently, the vast majority of mutual funds are “open-ended”--that is, on any given day an investor may buy or sell shares in the fund at their true market value. That’s no minor point: Investors’ confidence that they can pull their money at any moment is one of the reasons the fund industry has been so enormously successful since 1940. Easy in, easy out.
But that quality also can be a handicap for fund managers. There are many interesting small stocks or other securities that funds might like to own but can’t, simply because the securities couldn’t be sold quickly if fund investors rushed for the exits.
“It’s the cash flow into and out of a fund that wreaks the most havoc” with fund managers’ long-term planning and performance, argues Eric Kobren, whose independent Fidelity Insight organization tracks the mutual funds of Boston-based giant Fidelity Investments.
Thus, an interval fund or pay-back delay fund could offer investment companies a way to better manage their cash flows. That, in turn, could give them the option of boosting the number of illiquid, small-company securities that they own, with the idea of scoring at least a few huge gains among those high-risk securities over the long term.
“If a manager has the desire to start a fund that would hold less-liquid investments, this would seem to be the way to do that,” says William Lyons, senior vice president at the 20th Century mutual fund group in Kansas City, Mo.
The question is, do individual investors--via mutual funds--really want to boost their collective role as financiers of small businesses?
The idea has emotional appeal nowadays. With many banks and traditional venture capitalists turning their backs on small businesses, the $1.5 trillion in mutual fund assets may appear to be the national pot of gold, ready to finance the future.
More important, selling mutual fund investors on the concept of locking up their money for the true long haul should in theory be easier than ever: They’re already doing it with their retirement accounts, both IRA and 401(k), which many people never touch after choosing an investment.
Promise those investors a sexier return over time in small-company securities, and many of them may decide their inability to cash out of those funds in the short run may be unimportant.
There also is another important advantage in the hybrid funds, the SEC says: They could end the suffering of investors stuck in unloved “closed-end” funds. Those funds, a small subset of the industry, have a fixed number of shares outstanding, and generally trade on stock exchanges. You can sell them at any time on their exchange, but not necessarily for their true market value. They often trade at discounts, for reasons long debated.
By allowing closed-end funds to convert to interval funds, those investors would at least know they could receive true value periodically.
Barry Guthary, Massachusetts’ securities chief and president-elect of the North American Securities Administrators Assn., agrees the hybrid fund idea has merit. But he and some of his state-level peers also see danger in SEC Chairman Breeden’s cheerleading of the small-business finance issue.
“It’s strange the SEC finds itself in such a promotional guise,” Guthary argues. “They’re actually getting into product design now” to achieve a policy goal, he contends.
Guthary’s worry is that, by making it too simple for small companies to raise money from the general public, the SEC would open the door to rampant fraud, costing individual investors dearly.
Breeden has argued that state regulators are overdramatizing. Still, it’s true the Administration does have every reason to push hard for new business-financing ideas, however risky, that could boost depressed national psychology.
Isn’t long-term investing at higher risk the proven path to higher returns? Generally, yes. Can the mutual fund industry be trusted not to sell ridiculously risky hybrid funds? Overall, yes. What the hybrid proposal makes clear, though, is that more than ever the responsibility of protecting fund investors lies with the investors themselves.
