Redemptions aren't easy to combat

Mutual Funds

May 23, 1999|By Bill Barnhart | Bill Barnhart,CHICAGO TRIBUNE

Reports that investors are redeeming mutual fund shares to buy shares of stock directly continue to rock the fund industry. The trend has been driven largely by investor lust for computer technology stocks, especially Internet stocks.

While many investors are foolishly sacrificing diversification, the failure of most actively managed mutual funds to outperform stock market benchmarks makes it difficult for the industry to make its case.

John Bogle, founder of the Vanguard Group, sees a separate historical trend in the mutual fund industry that explains investor disloyalty and suggests a solution.

When the industry was beginning 60 years ago, diversified pools of investments had been organized for the very rich to rescue them from the hazard of having too much of their wealth concentrated in a few investments -- precisely the problem faced today by many nouveau-riche stock market investors.

Diversified investing was so successful that entrepreneurs pressed the in-house managers of these elite funds to extend the sale of fund shares to the general public. Initially, funds paid commissions to those selling their shares.

Soon, the selling function, called distribution, and the investment-advisory function merged into new companies that were legally distinct from the funds themselves, with separate owners and managements and business growth strategies that often conflict with the interests of mutual fund shareholders.

"What other trillion-dollar industry in the world requires outside companies to manage it?" Bogle asks.

This convoluted structure served a worthwhile purpose for many years. In the early part of the century, wealthy beneficiaries of trusts had little reason to share the wisdom of pooled investment programs with the great unwashed. Risk aversion and simple prejudice might have kept the benefits of mutual fund investing under wraps.

But a happy confluence of interests between old-fashioned salesmanship and old-line money brought the advantages of pooled investing to the general public through the young mutual fund industry. Now, the confluence of interests has become a conflict of interests between fund companies and mutual fund shareholders, Bogle says.

"You're not going to have a baby mutual fund industry without some parents to nurture it, without making a lot of investment in having it grow and in establishing its characteristics," he says. "But a child isn't a child forever.

"The mutual fund industry has come of age. We now have a sufficient database that I don't think we have to spend the rest of our lives worrying about educating people as to the benefits of mutual funds, much of which has not been brilliant marketing but the greatest bull market in recorded history."

Today, the enormous capital being invested to expand mutual fund organizations simply reflects the generous profits being reaped through fees assessed against an ever-larger amount of managed money, Bogle says.

"Every time one of these conglomerations happens, the mutual fund investor gets one step further removed from consideration," he says. "Fund fees will be regarded as a revenue source for [fund conglomerates] and not a cost source for the fund investor." With fee income of about $60 billion a year, the industry is clearing profits of $25 billion, a 42 percent return on revenue that would be the envy of any industry, Bogle estimates.

Recently, the Securities and Exchange Commission and the mutual fund industry's trade group, the Investment Company Institute, began to examine a possible solution to the conflicts of interest between mutual fund distribution and advisory companies, on the one hand, and fund shareholders, on the other.

Federal law requires the majority of mutual fund directors to be independent of the fund distribution company hired by the fund. The requirement, according to most experts, has failed to balance the interests of fund shareholders and fund distribution companies.

"I've talked to mutual fund directors who are not very comfortable with what's going on, but they don't quite know what to do," Bogle says.

"They can't kind of bring themselves to be confrontational, to take on the management and say roll the fees back, when the management will say the investors are willing to pay the fees."

Independent directors acting exclusively, effectively and publicly on behalf of fund investors are the best available solution to curb mutual fund redemptions, Bogle says.

Pub Date: 5/23/99

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