A Detailed Discussion on Mutual Funds

5 minutes to read

December 18th, 2018

by John M Ferraro


An early history of mutual funds

"The first modern investment funds (the precursor of today's mutual funds) were established in the Dutch Republic. In response to the financial crisis of 1772–1773, Amsterdam-based businessman Abraham (or Adriaan) van Ketwich formed a trust named Eendragt Maakt Magt ("unity creates strength")."

-from the Financial History of the Dutch Republic:

Courtyard of the Amsterdam Stock Exchange

His aim was to provide small investors with an opportunity to diversifyand hopefully spread out their risk by investing in multiple sectors of the Dutch and global economy.

It's original prospectus contained this (to give) "the investor of moderate means the same advantages as the large capitalist, in diminishing the risk of investing in foreign and colonial government stocks, by spreading the investment over a number of different stocks."

Talk about a brilliant idea for his time.

Remember in 1772 there were no computers, internet nor any real communication system.

Hand delivered, wax-stamped mail service or in-person meetings were the only ways to go!

The phone wasn’t even invented until 1876.

Investors had very little information on what to invest in, other than hunches of what was selling in general stores and talking directly to company owners.

The majority purchased stock in single companies and were subjected to a lot of risk if the company didn't perform well.

Information was hard to come by. Trading clubs met at local coffee shops or inns to discuss trading. Financial information was not easy to come by


Van Ketwich's solution: I could put together a team of economists, accountants and businessmen to review the books of all the publically-traded businesses.

Van Ketwich's problem: This solution would cost money since any decent economist would need to be paid.

Which leads to a side question: Did he do it for his own investing or was the intent to sell this information from the beginning?...


Getting the data for his new mutual fund

Once he had funding, he directed his team to collect sales, revenues, and debt information from each company's ledger books.

Then they would use the data to calculate EPS, Debt/Equity, Growth, Dividend yield, and other simple finance ratios.

Companies that didn’t keep good records would be eliminated first because of poor business practices.

With all of this data he could now sort all of the companies interviewed from best to worst.


Why would any Dutch company expose their books to this analysis by Van Ketwich?

Because they would hope to be better than other companies and attract investor attention.

It also benefitted the companies to be highly rated by a source (Van Ketwich) other than the banks, in the event they wanted to sell corporate bonds to raise cash.

Van Ketwich launched two more funds in next few years — Voordelig en Voorsigtig (profitable and prudent) and Concordia Res Parvae Crescunt (where there is harmony, small things will grow).


Dutch traders by rembrandt

He's making a list...

Now with a list of the highest rated companies from a financial fundamentals standpoint.

His brokerage's list of corporate investment opportunities would have a huge advantage over other investors.

So much so that the list could be the basis of a mutual fund of only the top rated companies in the country.

Now collecting all of this information wasn’t cheap and it’s cost had to be recaptured somehow.

If an investor wanted to not only invest in all of the top rated companies but diversify their account with one investment, they should have to pay for it.

This new mutual fund effectively was an investment paradigm change and investors flooded into it.


You're paying for the recommendations & the management of the fund

So bottom line, buying into this fund wouldn’t be cheap.

However, in most cases, it is still a much better option than buying individual stocks and securities you knew little to nothing about.

As the market matured, mutual funds set up three different options for sales charges to fit your investment time horizon.

  • The fund had a front end sales charge (when you bought in) Schedule A.
  • A Schedule B back end sales charge, when you bought out.
  • Schedule C is a level sales charge with no front or back end charges but higher yearly fees.

*There was also a 12b-1 sales charge that they passed on to investors to pay for marketing expenses.

This was usually forwarded to the investment advisor who brought in the investor.

young woman update a stock price at the NYSE

The big guy on the block... for awhile

The mutual fund soon became the the predominate market investment asset class for the next 200 plus years.

These guys had it really good for quite a long time and were able to charge accordingly for it.

Three major inventions changed everything though.

  1. The computer was invented in 1936.
  2. The internet was publically available in 1983.
  3. The exchange traded fund, or ETF, was invented in 1990.

These three developments, rivalling Van Ketwich's invention of the mutual fund, completely changed the investment world.

With computers connected to the internet, financial data now flooded users screen flowing from sites such as Yahoo!, Google, Morningstar, etc.

There was big money in providing investors with actionable financial data to make their investment decisions.

The Mutual Fund industry could feel their advantage slipping away.


ETFs

Now the next big investment paradigm change.

The first Exchange Traded Fund or ETF is invented in 1990.

Why?

Because hand collection of data was obsolete.

Any ETF fund manager has almost instant access to almost all companies financial data.

With the Mutual fund industry losing their advantage the ETF industry swooped in to pick up the investors at a much lower cost.

The mutual fund industry tried to fight back stating that their fund managers could produce superior results, but that soon turned out to be false.

So what happened to the 200 year old mutual fund industry that was deeply ingrained in most everyone’s company 401K plan, IRA, and other accounts?

The explosive growth of the ETF industry should have spelled doom for the Mutual Fund industry with their high sales charges(expense ratio) and front and rear end sales charges.

But they have still managed to survive.


Why do you think that is?

The answer is their war chest of funds from sales charges collected over the years.

A portion of that income that is handed out to financial professionals has enabled them to establish long term relationships with Investment Advisors, Brokerages, 401K administrators, etc.

These people have been getting paid for a long time by Mutual Funds.

They aren’t incentivized to switch their customers to low expense ratio ETFs because there is no money in it for them.

So the paradigm has changed, but the money being exchanged in the back office has not.


My Opinion

Don’t get me wrong... not all financial advisors are routing their customers into high expense ratio mutual funds.

But many still are.

Because the ETF industry was not able to take out the entire mutual fund industry, they turned on themselves.

They did this by lowering their expense ratios lower than ever.

Vanguard was first to take this step and soon followed by Schwab ETFs.

This should be a boom for all index investors.

You can find many of these ETFs with an expense ratio of around .05 while the average mutual fund is running around 0.5.

That’s ten times less.

There are lots of different types of funds too.

There are funds that follow a given index like the Dow, there are income funds, even bond-focused funds for fixed income.

Some even only invest funds based on ecological or religious principles.

They really can get that specific.


The moral of this story:

  1. Be aware of changes in the investment world.
  2. Talk to your financial advisor about your concerns.
  3. Question why you're invested in mutual funds (when you can be invested in a similar product for a 10X smaller expense ratio).