Chapter 10 Financial Dynamics of Mutual Funds Viewing recommendations for Windows: Use the Arial TrueType font and set your screen area to at least 800 by 600 pixels with Colors set to Hi Color (16 bit). Viewing recommendations for Macintosh: Use the Arial TrueType font and set your monitor resolution to at least 800 by 600 pixels with Color Depth set to thousands of colors

Copyright © Houghton Mifflin Company. All rights reserved. 10–1 Sales Loads: Shareholder- Paid Distribution Fees No-load or waived loads –Prevalent in the direct and retirement channels Front-end load –Prevalent in the intermediary distribution channel on Class A –Typically, a large portion of the load is re-allowed to the intermediary and a small portion is retained by the management company –Low-loads on the front-end are found in the direct distribution channel on certain funds (e.g., specialized funds)

Copyright © Houghton Mifflin Company. All rights reserved. 10–2 Sales Loads: Shareholder- Paid Distribution Fees (cont.) Back-end load (contingent deferred sales charge or CDSC) –Prevalent in the intermediary distribution channel on Class B –Typically, a CDSC schedule sets a load amount payable at redemption that declines over time to zero –To pay the intermediary for its sales efforts, fund sponsors must finance the up-front commission and hope to recoup it over time

Copyright © Houghton Mifflin Company. All rights reserved. 10–3 12b-1 Fees: Fund-Paid Distribution Fees Included in Annual Expenses for Shareholders Typically paid directly by the fund to finance distribution costs –Included in annual expenses passed through to fund shareholders –Maximum 12b-1 fee allowed by the SEC is 100 bp (75 bp distribution charge and 25 bp service charge) Will likely vary by class of fund –Class A typically includes a high front-end load and a low 12b-1 fee –Class B typically includes a high 12b-1 fee and a back-end load in the form of a CDSC –Class C typically combines a high 12b-1 fee and a modest CDSC for 1–2 years –Class I typically has no load and no 12b-1 fee All 12b-1 fees must be covered by a written plan –Approved initially by shareholders –Approved annually by independent directors

Copyright © Houghton Mifflin Company. All rights reserved. 10–4 Other Fund-Paid Fees Included in Annual Expenses for Shareholders Management or advisory fees –Usually the largest single fee paid by the fund –Pays for portfolio management, research, trading desk, and related support –Common structure involves breakpoint pricing –All-inclusive fees are offered for some funds –Performance fees may be part of other funds’ fee structure Transfer agent fees –Pays for shareholder servicing and reporting and transaction processing –Fees may take a variety of structures –Considerations include external versus internal TA/single or multiple markets

Copyright © Houghton Mifflin Company. All rights reserved. 10–5 Other Fund-Paid Fees Included in Annual Expenses for Shareholders (cont.) Other (miscellaneous) fund-paid fee –Pricing and bookkeeping –Audit and legal –Custody expense –Trustee fees

Copyright © Houghton Mifflin Company. All rights reserved. 10–6 Expenses the Fund Sponsor Incurs Fund management and research expense –Portfolio management, investment research, trading, and support –This expense has the biggest impact on the fund’s success Distribution expense –Marketing, promotion, selling, and support –May vary by size and age of fund Transfer agent and operations expense –Shareholder service and support –Other operations (e.g., 401(k) record-keeping)

Copyright © Houghton Mifflin Company. All rights reserved. 10–7 Economies of Scale

Copyright © Houghton Mifflin Company. All rights reserved. 10–8 Position: “Fund Expenses Are Too High” Total expenses of mutual funds have risen despite economies of scale that should be associated with a dramatically growing industry High expense ratios are associated not only with new funds but also with some mature funds Profit margins of fund management companies are too high, often exceeding 20%

Copyright © Houghton Mifflin Company. All rights reserved. 10–9 Position: “Fund Expenses Are Reasonable” There’s been a shift in the structure, not the amount, of costs –Loads (not included in fund expenses) have declined and –12b-1 fees (included in fund expenses) have in part replaced loads There has been a shift from lower-fee money market and bond funds to higher-fee equity funds

Copyright © Houghton Mifflin Company. All rights reserved. 10–10 Position: “Fund Expenses Are Reasonable” (cont.) Median expense ratios for funds started before 1987 has gone down, indicating some economies of scale Profit margins are below peak levels and are reasonable compared to other high knowledge industries

Copyright © Houghton Mifflin Company. All rights reserved. 10–11 Source: Investment Company Institute (ICI) Structure of Fund Industry: Asset Composition

Copyright © Houghton Mifflin Company. All rights reserved. 10–12 Largest mutual fund complexes by assets, 1990 versus 2000 Structure of Fund Industry: Industry Concentration Over Past Decade

Copyright © Houghton Mifflin Company. All rights reserved. 10–13 Mergers and Acquisitions Involving Fund Sponsors M&A activity increased throughout the 1990s –Trend coincided with stock market rise and general growth in financial services –144 publicly reported M&A transactions analyzed in a Merrill Lynch study 3 main M&A categories analyzed in study include –U.S. domestic transactions –Cross-border transactions –Foreign transactions (not discussed in the chapter)

Copyright © Houghton Mifflin Company. All rights reserved. 10–14 Mergers and Acquisitions Involving Fund Sponsors (cont.) General M&A trends during the 1990s –Early 1990s Transactions among U.S. financial firms were main focus Intraindustry activity focused on fund sponsors being acquired –Later in decade Fund sponsors began to become intraindustry acquirers Pace of cross-border transactions increased Acquirers paid higher and higher prices in anticipation of continued strong growth of revenues and assets

Copyright © Houghton Mifflin Company. All rights reserved. 10–15 The Case for Mergers in the Industry Economic factors—economies of scale –Overall asset size –Lower cost to buy than build –Reduction of overlapping costs Business factors –Product line extensions –Distribution expansion –Diversification

Copyright © Houghton Mifflin Company. All rights reserved. 10–16 The Case for Mergers in the Industry (cont.) L egal factors –Change in control terminates the advisor contract –Acquisition does not guarantee contract renewal –Need seller’s assistance to obtain required approvals

Copyright © Houghton Mifflin Company. All rights reserved. 10–17 Case Study: Merger Rationale for Major Stakeholders Directors and shareholders –Fund performance –Fees –Competitive factors Intermediary distributors –Compensation –Fund performance –Product line

Copyright © Houghton Mifflin Company. All rights reserved. 10–18 Case Study: Merger Rationale for Major Stakeholders (cont.) Fund company –Economies of scale –Fees –Product line

Copyright © Houghton Mifflin Company. All rights reserved. 10–19 American GuardianBest Management Patriot GrowthWestern GrowthIndustry Median Distribution Channel:Intermediary Type of Funds Sold:Domestic Equity Growth/Cap. App. Class A Transfer agent:OutsourcedInternal Size of Fund:$3B$2.5B Current Fees (%): Advisory Fees58 bp44 bp52 bp 12b-1 Fees25 bp(25bp to B/D)35 bp(30bp to B/D)25 bp(25bp to B/D) Service Fees15 bp19 bp17 bp Total Expense Ratio98 bp 94 bp Load Structure Front-End5%(4.5% to B/D)5%(4.5% to B/D)5%(4.5% to B/D) Case Study: Exhibit 1

Copyright © Houghton Mifflin Company. All rights reserved. 10–20 Newly Merged Fund American Patriot Growth Best Western Growth (1-Year Forward) $000 bp $000 bp$000bp Annualized Average Assets 3,000,000 2,500,000 Projected Gross Sales 0 250,000 Revenue: Sales Loads, Net (50bp) 00 1,250 5 Management Fees 17, , b-1 Fees, Net 00 1,250 5 Transfer Agent Fees 4, , Total Revenue 21, , Expense: Fund Management 7, , Sales Support 3, , Transfer Agent 4, , Total Expense15, , Pretax Income 6, ,000 8 After Tax Income (40% Tax) 4, ,200 5 After Tax Margin 18.9% 6.6% Case Study: Exhibit 2: 1996 Pro-forma P&L

Copyright © Houghton Mifflin Company. All rights reserved. 10–21 Case Study: Possible Exhibit 2 (Post-Merger)

Copyright © Houghton Mifflin Company. All rights reserved. 10–22 One Possibility Q6B—Best American: Newly Merged Fund Inputs for Comparison of Share Class Pricing

Copyright © Houghton Mifflin Company. All rights reserved. 10–23 Q6B—Best American: Newly Merged Fund Comparison of Share Class Pricing