MUTUAL FUND ASSETS AND EARNINGS OF MANAGEMENT COMPANIES, 1966 1 In the case of management companies, assets shown represent assets of all mutual funds under respective managements. STATEMENT OF JOHN R. HAIRE ON BEHALF OF THE INVESTMENT COMPANY INSTITUTE My name is John R. Haire. I am Chairman of the SEC Rules Committee of the Investment Company Institute on whose behalf I am appearing here today. I am also Chairman of the Board of Anchor Corporation, whose subsidiaries serve as investment adviser and underwriter of four mutual funds which comprise the Anchor Group-Fundamental Investors, Diversified Investment Fund, Diversified Growth Stock Fund and Westminster Fund. Combined assets of these funds exceed $1.8 billion, managed for the accounts of nearly 300,000 shareholders. My comments are directed to Section 12 of Senate Bill 1659 which would limit sales charges for mutual funds to a maximum of 5% of the net amount invested, which is equivalent to about 4.75% of the purchase price. We are opposed to this proposal first because it is unnecessary and is not justified by conditions in the industry, and second because it is inimical to the interests of the investing public. SALES CHARGES ARE ECONOMICALLY JUSTIFIED The pattern of sales charges which exists in the mutual fund industry today is the result of two basic factors: 1. Vigorous competition among more than 300 mutual funds, and with all other investment and savings organizations, in the open marketplace for customers who have a wide range of choice in the prices they pay for the investments they select. 2. The economics of distribution of mutual fund shares. The prevailing pattern of sales charges is illustrated in Exhibit 7 which shows that the maximum charges among 254 funds range from 8.85% of the selling price down to zero in the so-called "no-load" funds, of which there are 52. Of the other funds, there are 61 with varying sales charges below 8.5%, from which the small investor can choose. There is also a wide range of quantity discounts available with reductions of sales charges beginning with an investment from $2,000 up, as shown in Exhibit 8. In addition, different funds offer different services with or without charge. For example, many funds offer dividend reinvestment without a sales charge, while others do make a charge. The facts about sales charges are fully disclosed on the first page of the prospectus the investor receives when he considers a mutual fund purchase. This is unusual in American business. The buyer knows the markup. He is able to make a specific judgment about whether he considers the sales commission reasonable or not-and this is not true, so far as I know, of any other products that are regularly purchased by the public. The difference in sales charges among mutual funds reflect differences in their distribution systems and in the services they provide to investors. Shares of "no-load" funds are generally available only at the sponsor's office or by mail. On the other hand, most funds have found that a maximum sales charge of 8 to 82% is economically necessary to support a national distribution system. The methods and expenses of distributing mutual fund shares are entirely different from those involved in selling individual stocks. By and large, individual securities are sold by securities salesmen over the telephone to existing customers. This permits a high-volume, low-cost-per-transaction form of distribution. Mutual funds, on the other hand, are sold in a totally different manner because they are a totally different product. They are not ordinary securities. Instead, they are essentially long-term, comprehensive investment programs which contain a great many features not found in ordinary securities. In buying a mutual fund share, the investor obtains not just an equity interest in a single stock but a proportionate interest in a soundly diversified portfolio of 50 to 100 or more stocks of America's leading companies. Along with diversification, he obtains professional management of his investment and a level of performance which is almost always superior to his own capabilities. In addition, mutual funds have developed for their shareholders special services which are not available in other securities. These include automatic reinvestment of income dividends and capital gains distributions, accumulation plans, plans for periodic withdrawals of cash, and the convenience of owning one certificate representing an interest in many securities. Since mutual funds are complete investment programs and require considerable explanation, a sale generally requires time-consuming, face-to-face interviews in which the salesman must seek out and educate the customer to the advantages of common stock investment and then explain all of the various features of the mutual fund. A recent study by the National Association of Securities Dealers indicates that in his mutual fund activities the typical salesman makes about 18 sales contacts per week. Each sales contact consumes about 2 hours. The salesman average 1.7 sales per week, which means that he works approximately 19 hours for each completed sale. The fact that so much more time is required to make a proper sale of mutual funds requires adequate compensation for the salesman. The salesman's portion of the sales charge generally averages about 3% out of an 82% maximum sales charge. Another portion of the sales charge, generally another 3% is retained by the salesman's employer, the securities dealer firm, to offset its overheadincluding the cost of recruiting, training and supervising salesmen and the maintenance of long-term customer services. Many securities dealers, for example, have customers who purchased mutual fund shares more than twenty years ago and still own the same shares today. They have situations where, through gifts and inheritance, these shares have passed through three generations in a family without the payment of any additional commission. Yet these dealers have continued to render service to these accounts by providing tax information, tracing missing dividends and lost certificates, handling the transfers of gifts and inheritances, and many other valuable services-all without cost to the customer or remuneration to themselves. The final portion of the sales charge (about 2% of the maximum charge) is retained by the mutual fund underwriter to defray costs for SEC fees, registration fees in the various states, costs of printing prospectuses, preparing sales literature, maintaining regional offices and regional sales representatives, and advertising and promoting the sale of fund shares. This role, essential to the widespread distribution of mutual fund shares, simply does not exist in the day-to-day trading of individual stocks. And the SEC Report concedes that the mutual fund underwriting function is generally not a profitable one. In evaluating the cost of acquiring mutual fund shares as against ordinary securities, it is also important to recognize that the mutual fund investor is buying a broadly diversified portfolio of securities under continuous professional management. He wants and needs this diversification to reduce the risk of selecting one or two stocks on his own and managing them himself. Stocks such as General Motors, Dupont, and Sears Roebuck, for example, are generally regarded as being of highest investment quality. But in terms of individual investor risk, they do not compare in quality with an investment in a diversified, professionally-managed portfolio such as is represented by a mutual fund. 82-865 0-67-pt. 1-21 Last year the stocks of General Motors, Dupont, and Sears Roebuck all declined in value more than 30%. Dupont lost 40% of its market value during that single one-year period. There was not a single mutual fund in the entire country whose shareholders sustained such extreme losses. Similarly, if ten years ago you had bought at random any one of the thirty stocks which make up the Dow-Jones Industrial Average, the mathematical chances were roughly one out of four that your investment would today show a loss. By contrast, if you had bought at random any one of the common stock mutual funds in the United States which were operating ten years ago and had paid the full sales charge of 82%, the mathematical chances of your having a loss today would have been zero. You would have a profit, and no additional charge would be involved if you decided today to sell out. I believe I can safely say that in the past 27 years since passage of the Investment Company Act, there has never been a single ten-year period when an investor who bought shares in a common stock mutual fund and held them for more than ten years, regardless of the sales charge he paid, had a loss. It is this record which makes investment companies an investment of "quality" which simply is not comparable to any other kind of security. The SEC Report compares the cost of purchasing mutual fund shares with the cost of purchasing a single stock. We have already pointed out that this comparison is invalid because a mutual fund share is not a single stock, but a share in a diversified, managed portfolio of securities. Any such comparison would have to take into consideration the costs to an investor of obtaining a minimum amount of diversification by buying a number of stocks instead of just one. The investor would pay far more in commissions if he were to buy and sell stocks of just 20 of the 50 to 100 or more companies held in a mutual fund's portfolio. To illustrate: the median mutual fund purchase by regular account holders is $1,240. An 82% mutual fund sales charge covers both the purchase and sale of a $1,240 mutual fund transaction. The stock exchange commissions and charges payable on the purchase and sale of $1,240 worth of 20 listed stocks would approximate 12%. SALES CHARGES ARE DECLINING As a result of competition, average sales charges in the mutual fund industry have been declining-despite steadily increasing costs and expanding services. Some of these services and other benefits to investors, which have been initiated by the industry over the past 10 to 15 years, are shown in Exhibit 9. During this period, overall sales charges have been reduced by the introduction of quantity discounts on larger purchases, discounts for larger purchases made within thirteen months, and discounts based on cumulative purchases made over the years. As a result the average sales charge rate as a percentage of total industry sales has been declining. As shown in Exhibit 10, an analysis of sales and sales charges on fund shares representing about 85% of total industry sales shows that the overall sales charge rate decline between 1956 and 1966 from 7.00% to 5.73%, a decline of 18.2%. Within this overall decline, there has been a modest rise in maximum sales charges which apply to the smallest sales because these take as much time as larger transactions and are relatively more expensive to obtain and handle. We think, Mr. Chairman, that we are intelligent business people. We want our business to grow and I don't believe we are naive about the economics of distribution. I can assure you that any of us who offer fund shares with a sales charge would promptly cut those charges further if we thought such action would permit us to maintain shareholder services, to broaden public ownership, and to sustain our companies, our dealers and their salesmen. We have, as the record shows, reduced these sales charges as much as we prudently could-and I have no doubt that this trend will continue. But we are shocked that the SEC would propose a 44% cut in sales charges without providing any economic justification whatever for such a drastic slash-and without even estimating what the practical consequences would be. In proposing to experiment with sales charges, the SEC is tampering with the vital distribution system of the mutual fund industry which has been developing from the lesson of experience over the last several decades. A basic business problem of this industry stems from a unique benefit we extend to our shareholders-we offer them a redeemable security. When a shareholder wishes to cash in his holdings, the fund must, by law, buy his shares back at their current pro rata value. People buy mutual fund shares with the expectation that they will ultimately be cashed in at retirement, when the children are ready for college, when the new home is to be built, or whenever the family financial goal, whatever it might be, has been attained. The business significance of this is clear. The asets of the mutual fund industry currently total some $41 billlion. With a redemption ratio of 5.8% we know that in the next 12 months we will lose about $2.4 billion through normal shareholder exercise of the redemption privilege. Thus a basic business challenge for the mutual fund industry in the year ahead is to raise at least $2.4 billion in new capital to replace the capital lost through shareholder redemptions. This is necessary to protect the continuing investment of the fund's shareholders. The current levels of sales charges reflect realistically the need to cover the distribution costs incurred by underwriters, by dealers and their salesmen; and to provide dealers and their salesmen with economic incentives to help meet this basic business challenge. The SEC proposal could cripple the ability of the mutual fund industry to raise the capital needed to meet normal redemptions. This could plunge funds into net redemption, forcing them to sell portfolio securities on balance. A recent study for the National Association of Securities Dealers by the consulting firm of Booz-Allen Applied Research, Inc. clearly indicates that the members of the NASD would suffer a significant loss of income, and that many such firms would be forced out of business, should the SEC's proposals be adopted. Other witnesses will comment in more detail on the serious economic impact which the SEC proposals would have on securities dealers. We will only point out that adoption of the SEC proposals would throw many hundreds of small and medium sized dealer firms from a profit to a loss position and presumably out of business to the detriment of investors. It is important to recognize that the maintenance and continued healthy growth of the mutual fund distribution system is very much in the public interest. Effective distribution of new shares is important to the 4 million investors who now own mutual funds. If sales are maintained at a high level, incoming cash can be used to meet normal redemptions and a high level of the fund's assets can be productively employed in investments for the shareholders. Moreover, the continuing growth of mutual funds generally benefits existing shareholders by reducing the costs which they incur for management of their money and for overall expenses of the Fund. Effective distribution efforts are also beneficial to the investing public because they bring to the attention of average men and women the availability of a form of investment that has proved most suitable for people of modest means. A great many of these people would never have the opportunity to consider the purchase of mutual fund shares, if there were not effective national sales organizations to make contact with them. Mutual fund shares, like life insurance, must be sold to people; and the sales charge, which motivates the salesman, therefore works to the public's advantage. The average man has shown that he will buy life insurance only when he is urged and counselled to do so. Americans today have a vast amount of protection in the form of life insurance policies. They would not have this vital protection if insurance policies had not been actively sold to them. Those in the distribution end of the mutual fund business know that any appreciable cut in sales charges would drive a substantial number of dealers and salesmen out of the business, thereby depriving the small investor of the opportunity to learn of and invest in mutual funds. If the small investor does not learn about mutual funds he may select alternative forms of investment which involve greater risk or lesser return. This is plainly not in the interest of the American consumer. Moreover, the attendant squeeze on the profits of the dealers remaining in the business would make it much more difficult for them to maintain the needed programs for the selection, training and supervision of salesmen which Congress sought to improve in the enactment of the Securities Amendments Act of 1964. Mutual fund sales organizations compete with other financial institutions for salesmen. A principal source of competition outside of the securities business comes from the life insurance industry and, as the SEC's Special Study of Securities Markets recognized, many mutual fund salesmen switch between life insurance and mutual funds. |