Mutual Funds Turn 100. Can Investors Still Count on Them?

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. A novelty in financial markets made investing more accessible for everyday people a century ago. Mutual funds have grown to become the backbones of many retirement and brokerage accounts today, and this year marks the 100th anniversary of the first mutual fund. Why have they been a win for investors, and what should they expect in the future? Russ Kinnel is the director of ratings for Morningstar Research Services. He’s also the editor of Morningstar’s FundInvestor newsletter. Check out our conversation.

Thanks for being here Russ.

Russel Kinnel: Glad to be here.

Mutual Fund Industry Outlook

Hampton: So you have covered mutual funds for a long time. What is the state of the mutual fund industry today?

Kinnel: I think it’s pretty good. In some ways it hasn’t changed, but it’s changed in other ways, and I think there’s greater transparency, fees are lower, you have a lot more options. So I think there are a lot of good things. I think some of the weaker players that might have been around, say, when I started at Morningstar in the ‘90s have been weeded out. That has to be a good thing. So there are some good developments I think of the industry today. I think it’s a pretty investor-friendly industry these days. Of course, there are still ways it can improve.

How This Law Protects Investors Investing in Mutual Funds

Hampton: Now the mutual fund, the first one, was created in 1924, and it was the 1940 Act that provided the rule book. Describe how that law protects investors.

Kinnel: Yeah, it was really a transformative law. It put into effect things like the SEC would regulate mutual funds. Mutual funds had to disclose things like their objective, fees, their holdings. These we all take for granted now but really did mark a revolution for investors. This was coming out of the Great Crash and the Depression and so they wanted to find ways to protect investors who had gotten crushed in the crash. So they came up with these rules that have greater transparency, requires diversification. All these things we take for granted. A great development was custodians—that the funds don’t sit on the stocks and cash they get. They have to put it with a third party who holds on to it, and though that sounds basic, it means the managers can’t say, “I’m going to Hamptons for the weekend. Let’s dip into the customer money” and the funds have had scandals, but we haven’t had managers just directly stealing, and so again just some really simple basic things that have really protected investors and enabled people to reach their goals.

Mutual Fund Market-Timing Scandal

Hampton: Now there was one scandal that we actually talked about in this podcast last year because it was the 20th anniversary of the market-timing scandal. Can you talk briefly about what happened and the fallout and how it reshaped the industry?

Kinnel: It really was a shock to the system for the fund industry, and as it happened, it came on the heels of the 2002 bear market and so it happened to be at a time when investors were already angry. What we found was that fund companies were doing a number of somewhat shady practices. Not all fund companies, but there were things like market-timing, which meant you were allowing investors, like hedge funds and others, to go in and out of the funds more often than they were officially allowed and that essentially meant they’re offloading some trading costs onto the long-term investors of the funds, but there were other worse things. There was one fund company found to be tipping off hedge funds to front-run their trades. There were some managers’ investors who were taking advantage of sluggish pricing in their funds to exploit these pricing flaws in their own funds, and so there were a number of issues, and it really got investors angry. It led to some very big settlements, and fund companies had to pay off investors. It led to things like much greater compliance efforts and some other regulations, but it was really a big shock to a system of an industry that up until then had largely been scandal-free and really prided itself on being squeaky-clean.

Hampton: And because of that, many mutual fund investors flocked to ETFs right?

Kinnel: That’s right. They went to either index funds in an open-end format or ETFs. That definitely spurred the growth. It also moved them out of some of the fund companies that 1) got caught in the scandal and 2) particularly burned investors. So, growth-led companies that got caught in the scandal, like Putnam and Janus, people left them. They went to places like Vanguard and American and Fidelity and T. Rowe Price that had lower costs, didn’t get caught in the scandal, and also didn’t burn people so much in the bear market because they had value, they had more straightforward offerings, and so it really changed the industry quite a bit.

How Mutual Funds Can Stay Competitive to ETFs

Hampton: And ETFs they offer the cheaper fees, the tax advantages. How are mutual funds evolving to stay relevant and competitive?

Kinnel: Yeah, so there are a number of ways. One: They pay more attention to taxes now; Fidelity has been doing that more recently in particular, but others have done that, too. Some have lowered fees. Some have come out with either similar ETFs or actual clone ETFs. You can have an ETF share class of your fund, which helps with some tax advantages. And of course fund companies and ETF companies are largely the same; Vanguard and BlackRock have lots of both and Fidelity, too, though not quite so much on ETFs. So, they really have responded. I think money still is flowing to ETFs. So, fund companies are going to have to continue to respond.

Competition From Crypto ETFs

Hampton: Let’s talk about the arrival of crypto ETFs. Billions of dollars are flowing into these products. What do you make of this competition?

Kinnel: It is interesting because we’ve had entries of the smaller fund companies, but we also had Fidelity and iShares are right there with them, too. And it’s very controversial because we’re not sure: Is crypto real? Are people going to be OK in this? Is it a real asset class? In the Japan-inspired selloff we just had recently, we saw bitcoin go down really sharply, very quickly. And so people are still debating: What is bitcoin? What is crypto? What are its uses?

But now it really is a new area, with Fidelity and iShares lending credibility. The SEC finally allowing investors to own these. And it’s going to be very interesting. We talked earlier about diversification being a great virtue of mutual funds. But if you just have a bitcoin ETF, obviously there isn’t a lot of diversification: They just own bitcoin. So, it’s really hard to say where we’re going to go with this, but it’s become much more mainstream, that much we know.

Are Mutual Funds a Good Investment?

Hampton: Do you think mutual funds meet the needs of today’s investors? I mean, that’s from Gen Z to retirees.

Kinnel: I think very well. Fees have come down. Diversification is still useful. Transparency is still useful. There are so many securities around the world, bonds, stocks, that it’s really helpful to have that diversification. Even if, say, you like to pick a few stocks yourself, there’s so much to own. So I think they’re very valuable. I think one of the great innovations is things like target-date funds that are tremendously diversified, super low cost, and you buy them through a 401(k). So you’re investing every paycheck, which means kind of a great combination of good investor behavior and well-designed funds. So I think the fund industry is doing a really good job today, not perfect by any stretch, but I do think it’s largely serving investors’ needs.

Mutual Funds’ Greatest Achievement

Hampton: What do you think has been mutual funds’ greatest achievement in this first 100 years?

Kinnel: Wow. I think enabling middle class and other investors to reach their goals in a cost-effective way, and just providing that security in knowing you’ve got net asset value quoted every day. So you can get out any day. You’ve got fairly straightforward investment vehicles. So millions of people have reached their retirement because of mutual funds, and I think that’s a great accomplishment.

Are Mutual Funds Here to Stay?

Hampton: And do you think they’ll be around for a 200th anniversary, Russ?

Kinnel: Boy, maybe. I think if they continue to evolve, the investment world is evolving faster and faster, and so they have to continue to evolve, but I still think something like that will likely still serve investors and still be useful, even though I’m sure it will be incredibly different at the 200th anniversary.

Top Mutual Fund Picks

Hampton: In honor of the current 100th anniversary, can you tell us some top mutual funds that you think investors should consider?

Kinnel: I’ll come up with three. One is Vanguard Total Stock Market VTSAX, just because it really illustrates the points we were talking about. Super low cost, super transparent, incredibly diversified. It gives you the whole US stock market in one shot. It’s boring, which Jack Bogle loved boring, because boring means you don’t overreact. You don’t sell when things go down. You might not. And so I think that’s just really useful and just illustrates what’s great about funds.

Another one I’ll mention is Dodge & Cox International DODFX. International active management has worked pretty well. Dodge & Cox is a place where the managers and analysts make a whole career of it, and so they really are great fundamental investors and the fees are low.

Another one I’ll mention is Fidelity Tax-Free Bond FTABX, a muni fund. And it’s just another area that indexing isn’t perfect in. But again, it serves investors well. It’s hard to buy muni bonds on your own. It’s hard to get good prices when you do that because they don’t trade a lot. So having a really professional management like Fidelity’s muni team is great. And again, low cost, nice diversification.

Hampton: Russ, thank you for coming to the table and talking about the past, present, and future of mutual funds.

Kinnel: You’re welcome.

Hampton: That wraps up this week’s episode. Thanks for watching and making this show part of your day. The Investing Insights team asks that you give our podcast 5 stars to help others find the work that we’re producing for you. And subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to Senior Video Producer Jake Vankersen and Associate Multimedia Editor Jessica Bebel. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.