Here’s the bottom line of the mutual fund business: Investment companies hype what they sell and investors haven’t a clue what they buy.
That should come as no surprise to anyone who has tried to navigate the legalistic shoals of a fund prospectus or stumbled across the latest ad from XYZ Co. trumpeting its five-star-rated funds.
The numbers are old news: As of last December, one out of every four Americans–that’s 63 million of us–owns shares in one or more of the 6,270 mutual funds out there.
That adds up to nearly $3.7 trillion in assets. About half of all mutual funds are stock funds–rather than bond or money market funds. The assets of those, buoyed by a surging bull market that has lifted stock prices to record high levels– have grown on average nearly 40 percent a year in recent years.
That growth shows little signs of abating. So why was there such a cautionary air around the Investment Company Institute’s annual meeting here this past week?
Although the ICI’s own research data show that investors haven’t panicked during sharp market sell-offs in the last 50 years, the truth is that no one knows what a sustained down market would mean. The phenomenal growth of stock funds and the millions of investors who have poured tens of millions of their hard-earned dollars into those funds have done so primarily during one of the greatest bull markets in history.
That’s true for investors. It’s equally true for the people running the investment companies and managing the funds.
“Most people in the industry haven’t seen a bear market,” said Arthur Zeikel, president and CEO of Merrill Lynch Asset Management. “Since 1982, the stock market has been up an average 18 percent a year.
“We know too many investors are chasing fast returns,” admitted Lawrence J. Lasser, president and CEO of Putnam Investments. They are expecting a 20 to 22 percent return, he added: “They think this is normal market growth.”
On average, this century, the stock market has averaged about a 10 percent annual gain. But to expect double that is really not irrational behavior, said Zeikel. “Most of us are reacting to our own most recent experiences,” and recently those kinds of robust returns have been the norm.
The Vanguard Group’s index funds, such as that based on the Standard & Poor’s 500 index, have been very popular recently. But John J. Brennan, president and CEO of Vanguard, said the S&P 500 is, in truth, a sector of the market–large-capitalization companies–that is not without risk. “It is being presented as very low risk and that concerns us.”
And much of the media coverage of mutual funds has been star-oriented and focused on short-term results. James Glassman, who writes a column for the Washington Post, joked that his next would be on “10 hot mutual funds for the next 10 days.”
Chicago-based Morningstar Inc. awards stars to funds based on past performance and fund companies use those ratings–when they are favorable–in their marketing, much like movies trumpet the thumbs of Siskel and Ebert.
Of course, a thumbs-up from Siskel and Ebert will still be valid one year or five years into the future, whereas a five-star stock fund could tank by summer.
“It’s a highly competitive marketplace,” said Zeikel. “One way to distinguish your wares is to talk about performance. The stars have become the differentiation. I wish we didn’t have to do it, but everyone does it.”
“We have to be candid with our shareholders,” said Brennan, who noted that Vanguard recently distributed a pamphlet on bear markets to its customers.
That’s fine, note Zeikel, but not many people are listening to those cautionary messages. “Those of us who have been reminding people that markets don’t always go up have been dead wrong.”
Anyone who has tried to read a mutual fund prospectus knows they are written to protect issuers from liability, filled with “hereins” and “pursuant to’s,” rather than to inform.
Securities and Exchange Commission Chairman Arthur Levitt in January launched a “plain English” crusade to get the industry to start talking to its customers in language they can understand. “Tell them plainly what they need to know to make an intelligent decision,” he said at the time.
The mutual fund industry has, for the most part, embraced the effort. Prospectuses, admitted ICI President Matthew Fink, are “complex and unreadable.”
At an ICI conference session called “Plain English,” Nancy Smith, director of the SEC’s office of investor education, asked how many of the 50 or so professionals in the room could understand their own companies’ prospectuses. Not one hand was raised.
Given the $3.7 trillion invested in funds, said Smith, “the stakes are very high.” Making sure investors know what they’re buying, how much it costs and how risky it is, she added, is a “necessity and not a luxury.”
The SEC initiative will likely become a requirement by the end of 1998; some companies have already begun rewriting their documents. “It shouldn’t take 60 pages to tell a client about 15 stocks in a fund and what the fund hopes to accomplish. That’s about 45 pages too many,” said Stanley L. Craig, director of sales and marketing of defined asset funds for the Merrill Lynch Private Client Group.
The legalese currently used confuses people and makes them angry, he added. Nora M. Jordan, a partner at Davis Polk & Wardwell, who helped Merrill Lynch revise documents, said even those involved in the process couldn’t figure out what some paragraphs meant or why they were included. “Things get added to prospectuses over time; they never get taken out,” she said.
Heidi Stam, associate director of the SEC’s investment management division, urged all fund companies to begin looking at their documents now. “These rules will be adopted. It’s going to happen.”
