Pennsylvania Investment Observer

A Mutual Fund Alternative

by Daniel J. Nestlerode

Created in the nineteen twenties, mutual funds have been one of the most successful investment products in the last hundred years. Mutual Funds are a derivative investment product or one that derives its value from the holdings in its portfolio. According the Investment Company Institute, the trade group that represents the mutual fund industry, the industry has grown to nearly seven trillion (yes, that is trillion with a “T”) dollars in value. The fund industry manages this gigantic pool of money for purposes ranging from capital growth to tax free income and even as a substitute to bank savings accounts (so called money market funds). By most measures, the mutual fund industry is one of the most successful in the country.

Yet success breeds its own set of problems. One of the problems that success breeds is the notion that the industry has no problems. However, Elliott Spitzer, Attorney General for the State of New York, and the Securities and Exchange Commission has uncovered several problems in the operations and unequal treatment of various customer groups at mutual funds. Apparently, wealthy clients were receiving better deals from the funds than the usual main street client from Canton, Pennsylvania, in violation of the mutual fund’s legal document, its prospectus. Others were allowed to trade after hours, in violation of policy and others were charged incorrect sales charges based on the discounts allowed by the fund but inadequately interpreted and enforced by the brokerage and mutual fund industry. So, to say the least, there are a few problems in this heretofore pristine investment business.

Now the Securities and Exchange Commission (SEC) has proposed a series of point of sale requirements for the mutual fund and brokerage industry. In an attempt to provide more information to investors the SEC wants to sharply increase the costs, and resultant fees that investors will pay to participate in the mutual fund industry. Furthermore the NASD-R has pursued the brokerage industry relentlessly looking for clients who did not get all the discounts on sales charges that were due them. The issue is complex since each mutual fund group has its own definitions and discount tables. Brokers are required to effectively deal with various family relationships, accounts with other brokerage firms and changing discount tables. The amount of paperwork now required to move money from clients to the right mutual fund is starting to encourage brokers to seek alternatives to mutual funds for their clients.

Into this gap, a new product called Exchange Traded Funds (EFTs) has started to attract money that used to flow into mutual funds. ETFs are essentially portfolios of securities that are continuously offered like mutual funds, but are not actively managed. Running the gamut from industry specific funds to country specific funds, capitalization specific, and growth versus value investing specific, EFTs seem to cover the entire stock and bond market on a world wide basis. Different from mutual funds, ETFs trade like stocks and do not charge a sales charge and have lower expense ratios than most mutual funds. So the entire breakpoint issue that is now plaguing the brokerage industry is not applicable to the ETFs. From the investors’ viewpoint, ETFs also do not charge your account 12(b) 1 fees which are then paid to your broker. These attractive characteristics of ETFs have resulted in the growth of their assets to approximately a $150 billion as of the end of 2003, from inception in 1995.

In a free market economy, when an industry starts to have problems, others in the marketplace create new solutions or alternatives. From my point of view, the mutual fund industry is creating the ETF industry, by not dealing with and solving its internal and distribution problems. Now investors have another choice for their investment money and brokers have another product to offer their clients.

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