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Rekenthaler Report

Mutual Funds Are (Mostly) Getting Better

It's not your father's industry--thankfully.

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Round-Tripping
It's possible that the mutual fund industry was at its best in the 1950s, as Jack Bogle often suggests. In those innocent times, before the excesses of the Go-Go 1960s and the 1970s' "innovation" of the 12b-1 fee, a fund was a clean, simple thing. It held blue-chip stocks, investment-grade bonds, or both; its expenses were modest; and it was managed by partnerships that had old-fashioned notions of stewardship. The choices were limited but solid.

As I was not there at the time, I cannot speak to the 1950s. Certainly, though, the industry was not at its best 30 years later, when I first began to watch. Many changes had occurred since the Eisenhower days, generally for the worse. Happily, most of those problems have since been addressed. Broadly speaking, the fund industry has followed the shape of a "U," sliding from a high point in the 1950s down to its nadir in the 1980s, then rising to a new (but different) high point today. It's been a 60-year round trip, of sorts.

Costs Matter
Early mutual funds were cheap. They were launched with low management fees, no distribution fees, and pretty much went about their business in silence. The mutual fund business was originally a get-rich-slowly business. Over time, that mindset changed. The stock bull markets of the 1960s and then, on an even greater scale, the 1980s brought sudden wealth to "performance managers" who posted gaudy returns. With bonds, the high interest rates of the 1980s brought the opportunity to sell yield. Fund companies began to think about striking gold rather than mining profitable but sedate veins of copper.

This burgeoning sales aggressiveness led to soaring expenses. New funds carried higher management fees than did older, pre-existing funds, as fund companies hoped to raise additional monies for expansion. And funds of all ages began to tack on distribution costs. Their sponsors believed that performance alone was not enough to gather assets. Stories need to be told, to brokerage firms for load funds, and to the general public via advertisements for their direct-marketed rivals. These distribution fees became so common that funds were permitted to call themselves "no-load" even if they carried a 0.25% annual 12b-1 fee.

Investors didn't much notice or care that they were paying more. At the time, most shareholders believed that they got what they paid for. After all, Cadillacs cost more than Yugos for good reason. The Caddy's materials were more expensive, the engineering was superior, the production was more careful, and so forth.

Of course, the analogy was wrong. One fund costs more than another because…it does. There is no higher level of quality associated with the premium. Also, unlike with a car, fund expenses come directly out of the product itself. It is as if every extra dollar paid for the automobile detracts from its acceleration.

This line of thinking has by now become commonplace, such that I need not expand upon the explanation. And fund companies have responded by engaging in cost wars on existing index funds, and by issuing a slew of new low-cost funds, both in the traditional open-end format and with exchange-traded funds. Everybody realizes now that cost is critical.

Numbers Have Replaced Stories
In the 1980s, new mutual funds made a splash. Fund companies would host lavish events publicizing their new funds, prepping brokers as to how to make the pitch, perhaps rewarding those who moved the most product through a sales contest. Many assets flowed into funds so young that they had no Morningstar Rating, which is calculated after a fund has existed for three years. In the 18 months after its 1985 launch, for example, Putnam High Income Government gathered $11 billion--making it temporarily larger than every stock fund in existence, including legendary  Fidelity Magellan (FMAGX).

There are no comparable rags-to-riches stories these days, as almost all assets go into veteran funds. There are occasional exceptions for funds that are perceived to be new asset classes (mostly alternatives), for ETFs that show the performance histories of a back-tested index, and, very rarely, for star portfolio managers who change companies (most notably, Jeff Gundlach at  DoubleLine Total Return Bond (DBLTX)). Overall, though, the vast majority of monies go into large, established funds that are becoming even larger.

This is a good thing. Yes, giant funds can become overly conservative, because of the bloating effect of their assets and to managers playing it safe after they have accumulated their pots of gold. But there are worse sins for mutual funds than being dull. Chief among them is delivering a bad surprise, which was all too common among the new funds of the 1980s. The Putnam fund was in net redemptions before its second birthday and was merged out of existence a few years later. Investors who buy funds based on the numbers have a pretty good sense of what to expect. Those who do so after hearing stories, not so much.

Fewer Gimmicks
Putnam High Income Government held long Treasuries, sold call options on those long Treasuries, distributed income from both the long Treasuries and the proceeds from the options sales, calling that combination "yield," and suffered a gradual decline of its net asset value. There was really no escaping the latter. However, Putnam did not describe the fund's strategy so directly, leading early shareholders to own what they did not understand. They bought that fund believing they were getting a guaranteed-safety fund that would preserve their money while offering a great payout. They learned through experience about the fund's catches--high volatility and an eroding net asset value.

Most new bond funds were difficult to understand back then. Besides the options-writing "government plus" funds, there were high-yield bond funds, strategic-income funds, short-term multimarket income funds, and exotic-mortgage funds. Best--or worst--of all, there were "American government" funds stuffed with Mexican and Argentinian bonds. (Those countries are in the Americas, after all.) Bond-fund categories came and went, following the predictable pattern of attracting assets by offering an apparent free lunch, then losing those assets when the meal's bill arrived.

Admittedly, there remains a fair amount of trickery with bond funds: Nonconstrained funds that suggest the ability to negotiate any change in interest rates; bank-loan funds with high payouts and potentially low liquidity; and state municipal-bond funds that invest in Puerto Rico may well end up surprising their shareholders. So, too, might hedged foreign-currency funds when the dollar falls. Still, bond funds are clearly better than they were.

Equities have seen improvement as well. Stock funds historically have been more transparent than bond funds, and thus the source of less confusion. But there were some bad pockets in the past, such as market-timing funds and "theme" funds like Shearson's woeful 1990s Fund. Also, sector funds commanded a greater market share than they do now, as did concentrated, idiosyncratic funds that were as likely to disappoint as to delight. Today's index funds deliver fewer surprises.

Six of One, Half-Dozen of the Other
You may have noticed that most of the fund industry's changes have occurred because of shareholders' actions. Investors, after all, were the ones who voted with their wallets for cheaper funds, who decided to wait for track records before buying new funds, who redeemed gimmicky funds that annoyed them, and who now (mostly) seek plainer fare. For that reason, Morningstar headlined its 2015 Fee Study as "Investors Are Driving Expense Ratios Down."

And for that reason, I could have entitled this column "Fund Investors Are (Mostly) Making Better Decisions." That works, too. But I don't see how the angle really matters. While the fund industry--and investor decisions--remains far from perfect, it is better than in the past. From either perspective, that is a good thing.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.