Q. What trend do you see in the mutual fund industry?
A. The mutual fund industry is going through an unbelievably high period of growth. It topped $500 billion in assets. There are over 1,500 SEC-registered funds. Most of the growth has come in fixed-income funds. Any period of strong growth normally is followed by less happy periods. Either slower growth or decline. It's just the statistical nature of exponential growth.
Q. Why have fixed-income funds grown so fast?
A. For three reasons. First, most people have buried inflation. Second, when their certificates of deposit matured, they were used to, say, an 11 percent yield. So they went back to the bank or the S&L and said, 'Well, roll it over.' The institution said, 'We'd be happy to do it at 7.5 percent.' People said, 'No, I want double digits.' So they found their way to mutual funds.
Third, most of the sales of fixed-income products has been done by the brokers and, in many cases, by the newer brokers . . . because it's been a relatively easy sale to people that they probably couldn't sell anything else to. So you've had three coincident factors that led to the surge in fixed-income sales.
Q. Many of those sales have been in Ginnie Mae (Government National Mortgage Association) funds. Do you think people understand Ginnie Mae funds and how they work?
A. No, I think very few people actually understand that, first of all, there is an interest rate risk. If interest rates move up, all fixed-income declines. I don't think they understand the reinvestment risk of their principal because with a Ginnie Mae you get principal back along the way in an unpredictable fashion. So you cannot project out how much money you'll have at the end of a period . . . .
Q. How much risk is there in Ginnie Mae funds compared with other funds?
A. Well, it depends on the nature of the Ginnie Mae funds. Some funds, in order to try to add to income or to hold principal, invest in futures that adds, could add, some additional risk.
The credit risk issue on Ginnie Mae is a hypothetical issue. There's been no default and none is envisioned. It is backed by the full faith and credit of the U.S. government and has a backup loan arrangement with the Treasury . . . it doesn't trade as if it has the same credit standing as the U.S. Treasury.
Q. What do investors need to understand about funds like Ginnie Maes?
A. Well, first of all, they're investing, which means they are taking risk. The primary risk that they are taking is inflation, which has a way of forcing interest rates up. So that could be an unexpected. There is a second risk that they will get some principal repayment which they don't fully understand.
Q. How would that affect the investor?
A. It would change their rates of return. They would tend to get more principal back in periods of low interest rates than in high.
Q. So when the ads talk of an 11 or 12 percent return on Ginnie Mae funds, that's not necessarily as guaranteed as it sounds.
A. There is no guarantee. The U.S. government's guarantee is on the underlying Ginnie Mae issue of repayment of principal and timely interest. It doesn't say anything about the fund. The fund is not guaranteed.
Q. Both your principal and your yield can vary?
A. That's right. As a matter of fact, it's likely to. I mean interest rates, by nature, are not normally stable.
Q. Is there any way the mutual fund industry can make this clearer to investors?
A. The Investment Company Institute has a committee working on this. Clearly, this is a political issue within the industry. The SEC is very concerned about the issue.
Q. Do brokers take the trouble to explain this as well as they should?
A. Well, I'm sure the brokers are going to be blamed for not explaining, and I think in some cases that may be accurate. I suspect people hear selectively and they may actually be told it, and they didn't hear it.
Q. Which funds did best in 1985?
A. The best single group by investment objective were the health funds, and they were up 43 percent as a group, on average.
Q. What was next?
A. After that, it was international funds, which were up 39 percent, and then global funds, which were up about 37 percent. (International funds invest only outside the United States. However, globals invest anywhere, but by Lipper's definition must have at least 25 percent outside the United States.)
Q. Are either health funds, international or global funds likely to repeat their performances in 1986?
A. Once a trend gets headlines, it typically is decaying. In the first month, the international funds and global funds are still showing above average returns. Health is not, but it's not doing badly. Since there are only six health funds, you may see a different mix of performance there, particularly if the science and technology funds in general start doing well. Those health funds that are more technology-oriented could do well.
Q. Which funds might do best in 1986?
A. Well, I would say . . . gold, science and technology and natural resources which had done poorly, as well as some of the growth and income funds. As with all predictions, first it's a mistake to make them and second you win some and you lose some. Gold certainly has done very well (in January). Natural resources haven't. Science and technology is starting to do well.
Q. Do you think gold will continue to be strong?
A. I hope not because I think it's a barometer of a sense of trouble. But historically, I think you have to at least address the issue.
Q. Would you invest in funds that have done poorly in the past?
A. I think what you do is you try to find funds that have succeeded in various periods in the past and try to understand those periods and think about what are going to be future periods (of success.) Most people take the present and extrapolate it out. Where I think we differ is we say the future is going to be different than the present. We don't know what it's going to be, but we start to look, and I think very often the opportunities (are) with good managers (who have) done well in the past but are not doing well now.
Q. Do you see a return to inflation this year? Or down the road?
A. I see it down the road. I don't know when. I mean one of the reasons we look at gold is because one of the functions of gold, one of a number, is as a barometer of inflation. I don't see much other evidence on prices yet. Frankly, I don't have a great deal of confidence in the existing government-issued price indicators.
Q. What's happening to mutual fund fees?
A. The first thing that's happening is that fund management companies are labor intensive. And the price of labor has been going up. Second, there's been a tremendous proliferation of funds so that it's a more difficult marketing. Media prices have gone up so that the cost to distribute has gone up. The Securities and Exchange Commission has permitted the cost to be borne by shareholders as a specific item covered under a Rule 12b-1 plan (distribution fees) where in the past it typically came out of management fees. It's too early to say whether, from a shareholders standpoint, 12b-1 has been good or ad. But it has been effective at drawing people into the fund industry.
Q. In terms of sales
A. Yes. there are some people today that own funds that would not have owned them if it had not been for 12b-1.
Q. Why is that?
A. Because somebody was paid to inform them about the funds.
Q. It was the commissions that sparked the sales?
A. That's right.
A. 12b-1 fees are used for payng commissions?
A. They don't use the term commission. It's to aid distribution. Aids to distribution may be to banks to pay for tape-to-tape transport. It may be used as sales commissions with brokers/financial planners, it may be used to pay for advertising or printing. It's a permissive rule rather than an explicit rule.
Q. Some funds also have rear-end loads, or withdrawal charges. Are they taking advantage of the investor?
A. It's a good question, and again, it's too new to find categorical evidence. I don't think they're taking advantage, in the sense that it's disclosed. And I think it depends on the investor. If investors are using funds as they were originally designed, which is a long-term investment program, then they will not in most cases get hit by these contingent-deferred redemption fees that typically scale down over time and, in most cases, are over after six years. So I'm not particularly concerned there.
Where I am concerned is if somebody doesn't realize they're there and doesn't realize how funds are most appropriately used, and starts to trade them and winds up with an unexpected sales charge. However, to be fair to the funds, they have to recoup their sales expense in getting this investor into the funds.
Q. Is the industry doing enough to tell consumers about these fees?
A. I think they're doing all that the SEC requires.
Q. Is that enough?
A. Well, I have a problem. The SEC, albeit at the insistence of the industry, permitted this short prospectus followed by the part B or statement of additional information. I don't think in the short prospectus, the simplified prospectus, there's enough information.
Q. What would you prefer?
A. I would prefer a single document, perhaps arranged in descending order of interest, but have it at least in there. I would prefer more numericals up front and less legal definitions up front. I think they both are very important.
Q. When investors are reading your fund performance reports, should they be most interested in a fund that's done well for 15 years or a fund that did well last quarter?
A. Well, it really depends on whether you're a performance player or a policy player. If you're a performance player, you want to find those funds that are doing well on the theory that they will continue for some period. That may be till tomorrow . . . .
If you are a policy investor, you'd like to find the ones that have done well over time that are not doing well now. We don't think that you should start with performance. We think you should start with investment objective. What type of investor are you, and after you figure that out, what type of funds should you own with this particular chunk of money?
Q. And how much risk are you willing to take?
A. That's right.