This transcript is of a conversation I had with Theresa Hamacher (listen to the podcast), author of the new book, The Fund Industry: How your Money is Managed. You can always subscribe to Tradestreaming Radio on iTunes.
Today’s episode is all about mutual funds, the product and the industry. As a guest on the program we have Theresa Hamacher, a co-author of the new book, The Fund Industry: How Your Money is Managed. She co-wrote the book along with Robert Pozen. Hamacher is currently the president at NICSA, a position that she’s held since March of 2008. For those of you who don’t know, NICSA is the National Investment Community Service Association, which bills itself as the leading provider of independent education and networking forums to professionals in the global investment management community.
Theresa had her background in investment management before that. She was the chief investment officer, CIO, for Pioneer, where she oversaw $15 billion in global equity in fixed income assets. Before that she was the CIO of Prudential Mutual Funds, where she supervised over $60 billion dollars in assets. Earlier in her career she was an equity fund manager. She began her career as a securities analyst.
Clearly the book is written from Hamacher’s extensive experience and perspective within the mutual fund industry. I do broaden the conversation to try to incorporate how the mutual fund industry is coping with new product innovation in the ETF, the exchange traded fund community.
I think talking about mutual funds is an interesting topic right now. They are a well designed product for a variety of situations. There seems to be an overriding mantra that sort of was born out of do it yourself investing that somehow mutual funds are inherently bad. I don’t see things that way. They have their time and their place. They’re particularly good products for scenarios where it doesn’t necessarily make sense to have an index product.
Exchange traded funds are obviously the fastest growing security, in terms of gaining new assets within the industry. It’s also interesting to me that mutual funds view exchange traded funds as competitors, and not necessarily as just new products, or innovative products in the industry.
I ask Hamacher a lot of these questions, but one thing that’s important to me is that when I speak to investors they say first thing, “Mutual funds are bad.” They have a connotation obviously, particularly ones that are sold with the sales load of being expensive, and that’s true.
ETFs, for better or for worse, have introduced a new model where cost is first and foremost in an investor’s mind. Saving $0.10 per trade, while losing money in the bigger picture is not a good strategy for people. Sometimes I find investors are overly focused on cost, when they’re not necessarily looking at the broader view, which means that perhaps this particular fund, this mutual fund, outperforms over the long-term. It gets a little bit fuzzier, obviously, when we look at backdated research that the majority of actively managed funds don’t beat their indices.
On the other hand when I look at ETFs, an ETF is not an ETF meaning- this was an example I wrote about on the blog a couple of years ago, at that time there were three ETFs that tracked the Chinese market, broad-based ETFs. Now we have sort of more finite ETFs and more stylized, where you can invest in real estate in China, or high tech in China, small caps in China. These were basically the first products in the ETF world that addressed investing directly, or somewhat indirectly in China.
Performance varied widely between these products. What investors weren’t doing, but sophisticated people would do, if they were to look at these products, was once you look at their holdings and sort of their strategies it’s very clear that they didn’t have the same strategies. While one fund sort of invested in, I’d say almost overly invested in banking sector, just from a market cap basis those were the biggest companies in China, and that exposed you obviously to all the financial industry in China. The other, and I think this was the PowerShares Chinese dragon basically was an index based upon a lot of reverse mergers, sort of some smaller companies.
Because of that in the initial couple of years that these ETFs were running the performance was really different. So, an investor just finally said, “Well, I’m buying an ETF because it’s cheap and I want access into China,” didn’t really know what he was getting. This is an important issue, particularly as we’re seeing ETFs move more and more towards the actively managed product.
So, let’s just jump into the conversation with Hamacher. Again, her book is The Fund Industry: How Your Money is Managed. It’s as much a book about mutual funds as it is about investing. She takes a lot of time to even talk about the career path within the mutual fund industry. I think even though it’s written from the perspective of two very vibrant mutual fund industry participants, it’s a fair book in the sense that there’s a whole chapter talking about ETFs and sort of what they mean in the industry.
It takes a relatively good look at itself in the sense that where mutual funds come from, what are they good for, what are they not so good for, what investors should look for when they’re sizing up mutual funds. This is the type of book that for somebody who’s investing in mutual funds is very, very beneficial. It’s really such a broad-based book. It’s also really practical for somebody in the financial services industry who sells mutual funds, or who uses mutual funds as an investible product.
Let’s hear what Hamacher has to say.
Theresa Hamacher: It really was two sets of readers, one was my friends and family. They’re among the 87 million investors in mutual funds in the US. It was also written for me 25 years ago, when I was just starting out in the industry. You quickly become very expert in one aspect of it, but you’re serious about what’s going on in other areas, but just even sorting through the jargon can be very difficult. So, the book is careful to explain all the terms that you’re likely to hear, because once you kind of get through the vocabulary it’s not that difficult an industry to understand.
Do you think the event of 2007/2008 sort of propelled investors to say, “Hey, I own these in my retirement account. I’m not quite sure how they work. Let me go and investigate a little more.”?
Hamacher: Yeah, I think that’s definitely the case. I mean it’s always- you pay less attention when you’re making money than when you’re losing money. So, I think you are seeing folks wanting to know more about what they’re investing in.
I find it interesting, over 80 million US investors own mutual funds, but as I see in my practice they’re still quite misunderstood. I pose the question to Hamacher why she thought that to be the case.
Hamacher: I think it’s an educational fault. I do think that the public has learned a lot about mutual funds. When you think about money market mutual funds are what popularized mutual funds. They only really came around 30-40 years ago, but people are very comfortable with them, but you have seen a real evolution in the number of funds that are offered, so lots of new features in funds. Then also more and more people are getting introduced to mutual funds generally through their retirement plans.
So, it’s just a very big educational effort that it’s tough to keep up with.
You mentioned money market funds as the introduction that most investors have to mutual funds. Obviously they were a focus of attention during the credit crisis, can you talk about what regulators are sort of looking at there?
Hamacher: Right now, as a consequence of the Dodd-Frank legislation, the money market mutual funds are- there’s a lot of consideration as to whether money market mutual funds pose a systematic risk to the financial system. We’re still waiting to see whether they’ll be included in some of the structures that are being established to make sure that institutions are not getting too big to fail.
The industry is arguing rather vociferously against this, and pointing to the fact that generally the losses have been contained, but folks like Paul Volcker are arguing that they should be subject to much more stringent regulation, including capital requirements.
In my book, Tradestreaming, and on this website, and in this podcast I talk a lot about some of the changes that technology is bringing to the investment game. Can you talk about some of those changes?
Hamacher: Well, it’s kind of funny talking about the mutual fund world, which has been more resistant to a lot of that than a lot of other industries. So, yeah.
Well, we do have a chapter on the changes in the way that securities are traded in the United States, specifically equity securities. It wasn’t that long ago, only about 15 years ago that most equity securities, or a lot of them, were traded through the New York Stock Exchange, which had a physical trading floor. It was very easy for investors to see what prices that stocks were being traded at. But, because of technology the way stocks are traded has changed dramatically in the last decade. Most of the trading now takes place electronically. Everybody is still kind of getting used to this.
The other big change is that institutional investors now can trade without disclosing their prices or volumes through entities called ‘dark pools’. This being said it’s a lot easier for folks to trade kind of behind the scenes. What’s happening is that you’re seeing a group of traders, generally called high frequency traders, that try and figure out how other people are trading and do it just a little bit faster.
In that situation even the smallest time gaps matter a whole lot. We’re finding that some traders try and place their computers physically closer to the server that executes the trade. To you or me this doesn’t mean anything at all. The speed with which we trade from our home computer seems to be just as fast as the speed that computer placed close to the server trades at, but it turns out it executes a trade ever so much more slightly more fast, and that gives those folks an edge.
It’s interesting. Of course all of this is being studied a whole lot more in the wake of the flash crash. The SEC has made some recommendations. We’re still going to see what’s happening with all of that.
I think there’s a feeling that the markets overall aren’t as fair as they once were, however there is kind of a flip side to the fairness issue, which is a lot of mutual funds feel that the new systems allow them to trade much more easily than they could in the past because they can execute trades without- they trade in large size.
In the past it used to be possible for other traders to anticipate what they were doing, and trade in front of them, which is called front running, of course. They’re feeling in the changed trading environment that they have a better ability to execute orders for their share holders. So, it’s a very complex situation.
You talk about “open architecture” in your book, Theresa. Can you explain what that is?
Hamacher: Well, I think it’s a term that’s been in place for a long time in the US, starting with the trend of brokers, the wire house firms no longer being able to sell their proprietary mutual funds exclusively or predominantly to their clients. So, you’ve seen in the brokerage firms that they now offer a wide variety of competing mutual funds to their clients. That trend has become so entrenched that essentially you’re seeing it in every investment vehicle available to individuals, whether that’s a retirement fund or a variability annuity.
What we also looked at is that it’s trend spreading overseas as well, though it’s still less common in places like Europe than it is here. But, it does offer individuals much greater choice, and we think it leads to lower pricing.
I guess from a business point of view in a book all about mutual funds, if one of the results of open architecture is sort of I would say some type depressed pricing in the mutual fund industry, what is the mutual fund industry doing to sort of combat that? Are they focused more on innovation and creating new products?
Hamacher: Yes, though I’m not sure all firms are necessarily combating that. You certainly see firms that are really embracing lower pricing and making that one of their selling points. I think the issue for the industry is more that it becomes tougher to differentiate your products. So, advertising for instance has become critical, grand differentiation. You can no longer rely on an exclusive set of sales people to promote your products. You really have to make them stand out in the mind of consumers.
Do you think these sort of same trends are pushing some of the mutual fund companies to buy ETF assets also?
Hamacher: Yes. I mean consumers are becoming more attune to pricing. As we talk about in the book too, ETFs are largely index funds. There has been a general trend toward increasing use of index funds, though that tends to move in cycles. The combination of the two has really driven more interest in ETFs, both from consumers and from fund management companies.
I think you do a fair job in the book sort of benchmarking mutual funds against ETFs, obviously. One of the things, I guess sort of being an outsider to the industry, that’s always sort of confused me is- obviously the way they approach asset management is different. You mentioned most ETFs are passive, although we are seeing an introduction of actively managed ETFs, why aren’t ETFs and mutual funds sort of considered similar products, at least from the industry side?
Hamacher: That’s actually a really good question. I think to some extent it’s historical. They have generally been handled by different types of firms. The fact that they are index funds as opposed to most of the industry still focuses on actively managed products.
From an administrative standpoint they’re very different. You don’t have a large transfer agency operation for ETFs, so you don’t have the large phone banks supporting customer service that you do with the traditional mutual fund.
So, there are a whole bunch of reasons.
They also appeal to a different audience. ETFs are more likely to be used by institutional investors than traditional mutual funds. They’re more likely to be purchased by the traditional stock investor. So, there are a number of reasons why they’re different.
The mutual fund industry, I guess I’m trying to understand the perspective, do they see ETFs as competition, or do they see it as sort of ‘mutual funds 2.0’, or somewhere in the middle?
Hamacher: I think it’s somewhere in the middle.
Our take on it is they’re very, very strong competition for index funds, in fact you see a lot of the index fund managers introducing ETFs I think for that very reason. Our perspective is that it’s going to be very difficult to have true actively managed ETFs. The ones that you’ve seen so far are active management, like, it’s largely index funds with some sort of mild active management component. But, because ETFs have to disclose their portfolios at least daily, it makes it tough for them to be actively managed. It becomes far too easy for market participants to front run an actively managed fund that’s disclosing its holdings daily.
Do you see some of the competitive dynamic of ETFs influencing to the positive the mutual fund industry in terms of I guess new strategies? Or, does the mutual fund industry just sort of see them as upstarts sort of chopping at the away at the passive indexers’ heels?
Hamacher: Well, a lot of the introductions of the new product types in the ETF area have been extremely aggressive funds. I’m not sure a lot of people view that as a very good thing, in fact some of those funds have been the subject of lawsuits post the credit crisis; the leveraged ETFs, the ones that multiple in market movements by two or three times, either on the up or the down side.
So, I think the innovations have been more the ability to trade throughout the day were, I say, the innovations that have been seen as most valuable; the ability to trade throughout the day, the constant downward pressure on costs. And that’s where the bulk of the assets and ETFs are at this point anyway.
I’ve been following sort of this, from a distance, this issue that Russell, the indexer, has been filing for exemptive relief to introduce its own ETFs, actually, and essentially sort of bypassed the process and bought an asset manager to try to get that exemptive relief.
The whole idea of an indexer getting into the actual hands on management game is really interesting. I think it’s sort of riddled with conflicts, but can you talk a little bit about that, and sort of your view on that?
Hamacher: You know, I’m not sure I have a particularly strong view on it. I guess it’s not surprising that it’s happening. Maybe it is surprising that it’s taken so long for this to happen. We’ll just have to wait and see. I’m not sure I see a lot of conflicts in it, but I’m interested to see what the comments will be.
What’s the impetuous to get into the game? Just they see an opportunity there to acquire assets, or is it a different type of product?
Hamacher: I’m guessing that they see opportunity to make more profits by doing it themselves, and receiving licensing fees from others.
That puts them into direct competition with all their licensees?
Hamacher: That’s correct. Right. But, you know the industry has sort of demonstrated that just having the product isn’t sufficient. You have to have the distribution too. So, whether a Russell would be able to establish itself in marketplace as well as some of the established index fund providers, I don’t know.
I got a chance to ask Hamacher a personal question. After years of working within the mutual fund industry she now works at NICSA, working with the mutual fund industry. I asked her how that transition went.
Hamacher: Well, it’s great. I love what I’m doing right now. I’ve loved everything that I’ve done. I really love the variety of it too. I actually think I have a really great job at the moment, because it combines a lot of the things that I most like, which is talking about investments, kind of looking at the bigger picture of the industry, and then also heading up NICSA, which is a mutual fund industry association. I get to work with a lot of really great volunteers who are working on educating the industry, largely on regulatory related issues.
That was my conversation with Theresa Hamacher, along with Bob Pozen, co-author of The Fund Industry: How Your Money is Managed, came out under a widely financed title in February. Great book on the mutual fund industry, on the mutual fund product, how investors should use mutual funds. The book belongs on every investor’s bookshelf, both professional and individual. It even gives a little bit of insight into the career path within the industry.
We’ve spoken a lot about mutual funds in the past, and we’ll continue to talk about them in the future. I do believe that they have an important role currently and in the future with investor’s portfolios. They are going to be challenged coming up with actively managed exchanged traded funds. Although we’ve seen a few enter the market already, there really hasn’t, as Theresa said correctly, there hasn’t been that much innovation so far. There’s a slew of them in registration, and expect to see them probably by the end of 2011/early next year. We’ll keep our eye on that, and keep reporting on that.
This is Zack Miller, this is Tradestreaming Radio. You can find more information on my website, https://www.tradestreaming.com, and you can find this podcast on iTunes. Thanks for joining us and we’ll see you next week.
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