Turbulent times bring out the best and worst in every aspect of financial investing. Once again, mutual funds are proving to be an appropriate investment for individuals, families and small organizations. Mutual funds are safer and less volatile in turbulent times because of their professional management, diversification, transparency, and governance structure.

Funds are Safer than Individual Stocks

Investing in mutual funds has proven to be safer than investing in individual securities. In a famous speech to the fund industry in 2003, Matt Fink, the then President of the Investment Company Institute, pointed out:

 "Morningstar recently calculated that in 2002, 20 percent of individual stocks lost 60 percent or more. About one-tenth of one percent of equity mutual funds experienced a loss that large.  In other words, at the start of 2002, an investor's chance of choosing a stock that would lose at least 60 percent of its value was one out of five.  An investor's chance of choosing an equity mutual fund that would lose that much was only one out of 807."

MPI has reproduced this analysis using the Morningstar database of mutual fund and stock performance for the year to date to mid-October 2008, to see if the results after the sub-prime contagion parallel those after the tech bubble and burst. We found that 1 in 5 stocks have lost 50% or more in value whereas only 1 in 50 equity funds have lost the same value. In other words, an investor has a ten times better chance of retaining his or her money in turbulent times when invested in mutual funds.

The reason for this difference is predominantly because mutual funds are professionally managed and by their nature are diversified over many different securities. An additional reason for the comparative success of mutual funds is that their governance structure - a board of directors - provides fund shareholders with diligent and knowledgeable oversight of their investment.

Fund Directors are Efficient and Cost Effective

 Unlike any other financial product, mutual funds have directors as an extra layer of governance to protect the shareholders interests. In turbulent times this added assurance is particularly valuable. Let’s look at some of the advantages:

• From a fund shareholders point of view. The cost of mutual fund directors to fund shareholders is quite small, especially when compared to the significant impact they have on overall fund expenses. In 2007 the total board director cost was an average of $14.23 per $1 million.  On average the total expense ratio of all mutual funds approximates 1% or $10,000 per $1 million.  Therefore fund directors have leverage over fund expenses of 703 to 1 (i.e. $10,000 divided by $14.23).
• From a taxpayer and regulatory point of view. There are about 400 employees of the SEC who regulate mutual funds. These are supplemented by roughly 2,600 independent fund directors, bringing the total number of individuals responsible for oversight to around 3,000.  The US retail banking industry is approximately the same size as the mutual fund industry. There are about 30,000 bank regulators at the federal, state and local levels. 
• Compared to other countries. The United States is the only country which mandates independent mutual fund directors with the authority to annually renew the advisory contract. An analysis of the total expense ratios of funds in a variety of countries showed that all were higher than the US. The expense ratio of equity funds in Belgium averaged 65% higher; for Germany 67% higher; for the UK 74% higher; for Austria 124% higher; for France 125% higher; for Luxemburg 127% higher; and for Canada 154% higher.
• Compared to public companies. Mutual fund directors are many times more cost effective than corporate directors in terms of their impact on the capital markets of the United States.  The comparative economic impact of directors of the largest mutual fund complexes is 30 times that of directors of NYSE listed companies.

Fund Directors Likely to Play Key Role in Secretary Paulson’s Regulatory Blueprint

 Whoever wins the upcoming election, it seems clear that the country will undertake a complete rethink of regulation of the financial industry. And it seems reasonable to expect that this conversation will start with the blueprint advanced by Treasury Secretary Paulson in March 2008.

 This blueprint called for three types of financial regulation: (1) a Market Stability Regulator, essentially to promote macro-economic oversight of the stock, commodities and futures markets as well as hedge funds, (2) a Prudential Financial Regulator to oversee all types of banks and insurance companies and (3) a Conduct of Business Regulator to oversee the functions which interact with the public (probably including the present SEC, CFTC and FINRA) for financial products and services like mutual funds, corporate stocks and bonds as well as mortgages.

 At this stage no one knows how independent mutual fund directors will fit into Paulson’s scheme. But what is clear is that mutual funds in their present form have served America well and their independent boards have provided inexpensive and effective governance, accountability and transparency, even in the most turbulent of times.