Recent trends in the mutual fund industry.

Mutual fund assets have grown more than twelve-fold from 1980 to mid-1993 and by half in the last two years of that period. Most of this growth has come from net purchases of fund shares by the public, rather than from price appreciation, and it has lately reflected a choice by investors to move funds out of depository institutions. In 1992, the public made net purchases of $206 billion of mutual fund shares, while making net withdrawals from their deposits at banks and thrift institutions. In turn, mutual funds supplied about one-fourth of funds raised by the domestic nonfinancial sectors of the economy last year, while depository institutions provided only about one-tenth. In short, mutual funds are now a significant competitor of depository institutions for household savings and, with more than $1.8 trillion in assets, they are a major source of funds in the capital markets.

Several factors underlie the recent surge in mutual funds. One is the drop in rates on deposits--especially short-term deposits--to relatively low levels at a time when rising stock and bond prices have been generating higher returns. As a result, households seeking to maintain satisfactory returns on their savings have been drawn to capital market instruments, especially mutual funds, whose diversification and liquidity offer advantages over direct investments in securities. In addition, the benefits of economies of scale in the mutual fund industry have been shared with investors through a widening array of services provided by fund families. Finally, many funds have eliminated or substantially reduced the sales commissions, or loads, they charge to investors.

Corporations with access to the capital markets, including firms with lower credit ratings, have benefited from the expanded supply of investment dollars represented by the surge in mutual funds. State and local governments also have benefited, with inflows to tax-exempt mutual funds running at a record pace since the end of 1992. Moreover, in recent years, smaller corporations raising equity through initial public offerings, as well as established firms, have seen mutual funds purchase a significant portion of the new equity they have sold.

In response to the growth of the funds industry, banks have increased their participation in the provision of mutual fund services. For example, many banks sell mutual fund shares to their retail customers and, in some cases, act as an investment adviser to mutual funds and provide other related services. The increased involvement of banks has brought attention to their role in the sale of mutual fund shares, including their responsibility for ensuring that customers are made aware of the differences between mutual fund shares and insured deposits.

The expanding role of mutual funds has had at least two important implications for the performance and structure of the financial markets. By offering households more diversified investment opportunities and corporations a greater market for their financial instruments, mutual funds have improved the efficiency of financial intermediation by reducing transaction costs. And as intermediaries competing with banks and thrift institutions, mutual funds have contributed to the reduction of the role of these depositories as providers of credit in the intermediation process and consequently have affected the relationship between money and economic activity.

TYPES OF MUTUAL FUNDS

A mutual fund is a type of investment company. An investment company sells shares or certificates that represent an interest in a pool of financial assets; a mutual fund (technically an open-end company) is an investment company that continuously issues and redeems its shares. The price of such shares, apart from any brokerage commissions, equals the net asset value of the fund, determined by dividing the market value of the fund's assets, less any liabilities, by the number of outstanding shares. The net asset value is calculated daily as of the close of U.S. securities markets. Open-end funds must redeem their shares on demand at a value equaling the next calculated net asset value and mail proceeds within seven days.

Another type of investment company, the closed-end fund, does not redeem its shares but typically offers a fixed number of nonredeemable shares that are bought and sold on a stock exchange.(1) A third type of investment company is the unit investment trust. Unlike other funds, unit investment trusts hold a relatively fixed portfolio of securities that is not actively managed.

The greater liquidity of open-end funds has helped make them by far the most popular form of investment company. By mid-1993, open-end funds--the focus of this article--held assets of about $1.8 trillion (table 1), as compared with only $90 billion of assets in closed-end funds.

  1. Net assets of the mutual fund industry, by fund type,
end of period, selected years, 1960-93:H1
Billions of dollars
Period    Stock    Bound    Money     Total
                           market (1)

1960       11.9      5.1    n.a.       17.0
1965       25.2     10.0    n.a.       35.2
1970       38.5      9.1    n.a.       47.6
1975       32.4      9.8     3.7       45.9
1980       41.0     17.4    76.4      134.8

1985      116.9    134.8   243.8      495.5
1990      245.8    322.7   498.4    1,066.9
1991      367.6    440.9   539.6    1,348.1
1992      475.4    580.9   543.6    1,599.9
1993.H1   581.6    673.7   549.8    1,905.1
1. Taxable and tax-exempt.
Source: Investment Company Institute.

For the most part, the portfolio of a mutual fund consists of marketable securities, both domestic and foreign, such as corporate stocks and bonds, government bonds, municipal bonds, and money market instruments. An individual mutual fund, however, invests in a specific subset of securities defined by its stated investment objective. For example, a money market mutual fund invests in a diversified pool of short-term money market instruments, such as commercial paper, certificates of deposit, and US. Treasury bills. Long-term mutual funds are those that invest primarily in stock and bond securities. Because they use certain share valuation techniques based upon historical costs, money funds are allowed to report a constant $1 share value.(2) Stock and bond mutual funds, on the other hand, must report their share values at market prices; hence, investor accounts in these funds may show a gain or a loss on any given day, apart from any distributions.

THE STRUCTURE AND REGULATION OF MUTUAL FUNDS

A mutual fund typically is organized as a business trust or corporation. The board of directors, elected by the shareholders of the fund, is responsible for overseeing the fund's operations. Among the board's duties is the selection, subject to shareholder approval, of an investment adviser to oversee the day-to-day management of the fund.(3)

Responsibilities of the investment adviser include making appropriate investments in line with the fund's investment policies and objectives and conducting economic and financial research. For these services, the adviser receives a fee based on a percentage of the fund's assets. Within certain limits, the adviser's fee income increases with the amount of assets under management, an arrangement that gives the adviser an incentive to perform well and to attract new investors. In some cases, the adviser's compensation also varies with the fund's performance relative to some specified benchmark.

The board also retains an independent custodian to hold the fund's assets in trust (except occasionally in the case of a bank-advised fund) and selects a transfer agent to maintain shareholder ownership records and to process orders for sales and redemptions. Governed by the Investment Company Act of 1940, the custodial arrangement is designed to prevent misuse of the fund's assets by the investment adviser. The services provided by the custodian include settling securities transactions, receiving dividends and interest, and making payments for the fund's expenses. Typically, the custodian's compensation varies with the volume of assets under management.

The board also hires an underwriter to sell fund shares either directly to investors or indirectly through brokers.(4) Depository institutions may also sell shares to their customers. Shares in some funds are sold at a premium over the net asset value. This premium, or "front-end load," covers, where applicable, the underwriter's cost, the broker's commission, and other sales and promotional expenses incurred by the fund.(5)

In direct sales or marketing, the underwriter offers shares to investors through the mail, by telephone, or at fund offices. Direct marketers usually do not charge a load; some no-load and low-load funds, however, use annual fees to finance the distribution of their shares to the public.

The Investment Company Act of 1940 is one of several federal statutes governing mutual funds. One of the primary objectives of the act is the protection of investors against abuses, and it contains specific requirements that the mutual fund be operated in the best interests of the fund's shareholders. For example, the statute places restrictions on changing a mutual fund's investment policies without shareholder approval, provides that the adviser's compensation be approved by shareholders and annually approved by the board of directors, prohibits conflict-of-interest transactions between the fund and its affiliates, limits the mutual fund's use of financial leverage, and requires mutual funds to pay redemption proceeds within seven days except under extraordinary circumstances.

Other aspects of mutual fund operations are governed by three other federal statutes: (1) Pursuant to the Securities Act of 1933, mutual funds must provide investors with accurate information about its investment objective, yield, and operating procedures through a prospectus. (2) The Securities Exchange Act of 1934 requires the registration of brokers and dealers with the Securities and Exchange Commission (SEC) and sets certain requirements for the solicitation of shareholder votes and proxies in connection with shareholder meetings. (3) The Investment Advisers Act of 1940 requires the registration of all mutual fund advisers (other than banks or bank holding companies), prohibits fraudulent practices, and gives the SEC enforcement powers.

To determine if the regulatory requirements are met, the SEC reviews disclosure statements and conducts on-site examinations. The SEC reviews fund disclosures about operating plans, management structure, and financial condition. On-site examinations typically probe the funds' valuation techniques, investment activities, management functions, and sales and liquidations of shares.

THE ROLE OF MUTUAL FUNDS IN THE FINANCIAL SYSTEM

Like other financial intermediaries, mutual funds channel savings to different forms of investments. To the saver, mutual funds offer several advantages over the closest, nonintermediary alternative--the direct purchase of stocks and bonds. First, by pooling the savings of many investors, mutual funds can afford to employ professional asset managers and analysts with investment expertise exceeding that of the typical small investor. Second, mutual funds allow small savers to invest in a diversified portfolio, thus reducing their exposure to certain types of risk. Typically, the higher transactions costs and minimum purchase sizes encountered in direct investment make diversification difficult for the small investor. Finally, mutual funds offer investors a greater degree of liquidity than would be available through direct investments in the capital markets. For example, mutual funds offer a variety of convenient means for purchasing and redeeming shares, such as making fund investments and portfolio adjustments over the phone and (for money market funds and some bond funds) making redemptions by writing checks.

Mutual funds are distinct from other intermediaries, especially depository institutions, in the way they channel savings. In raising funds, mutual funds issue shares that represent an ownership interest. Shareowners assume all the market risk and credit risk of the fund's assets and share proportionally in all the gains and losses of the fund. Consequently, the return on the shareholder's investment fluctuates with general market conditions and the investment performance of the fund. Banks and thrift institutions, in contrast, primarily issue deposit liabilities with a fixed rate of interest. Most depositors are fully protected by deposit insurance and are not subject to any credit risk.

In supplying funds, mutual funds primarily specialize in marketable securities of firms that have access to the capital markets. Funds must confine their investments to marketable securities in order to meet investor redemptions in a timely manner.(6) Although depository institutions purchase marketable securities, their special role is in providing funds to borrowers who, because of their small size or the complexity or monitoring requirements of the debt contract, may lack access to the public securities markets.

Mutual funds actively compete with banks and thrift institutions for the balances of households and in supplying funds to borrowers. Such competition is limited, however, to those households that are willing to take on additional risk for higher expected returns and to those borrowers capable of financing their needs directly through the securities markets.

THE DEVELOPMENT OF MUTUAL FUNDS

Offered in the mid-1920s, closed-end funds gained acceptance ahead of open-end mutual funds; in 1929 they accounted for 95 percent of industry assets. Open-end mutual funds, however, soon overshadowed them, and between 1940 and 1970 their assets grew more than a hundredfold, to about $48 billion. Throughout this period, they almost exclusively invested in equity, although bond funds also emerged and grew.

In the early 1970s, when volatile stock market conditions along with persistent inflation reduced the attractiveness of bond and equity funds, the industry created money market mutual funds. These funds met the desire of investors to benefit from money market rates, which were then above the level that federal regulation allowed depository institutions to offer on retail accounts, and the success of these funds spurred the development of other funds investing in fixed-income securities: Municipal bond funds were introduced in the mid-1970s, and mortgage-backed and government bond funds were started in the mid- 1980s.

Mutual funds have continued to play an active role in equity markets, with holdings of equity funds growing from about $40 billion in 1970 to about $580 billion in the first half of 1993. Bond and money funds grew faster over this period, however (chart 1). As a result, the assets of stock funds declined from about 80 percent of industry assets to 34 percent between year-end 1970 and mid-1993, by which time bond funds accounted for about 40 percent of industry assets and money funds about 26 percent (chart 2).

Money Market Mutual Funds

Money market mutual funds grew rapidly in the late 1970s and early 1980s, when interest rates on money market instruments exceeded regulatory ceilings that applied to depository institutions.(7) Flows from depositories to money funds supported expansion of the commercial paper market, an important alternative to bank loans for businesses. The growth of money funds was interrupted temporarily in 1982, when banks and thrift institutions were permitted to offer money market deposit accounts, which were not subject to interest rate ceilings. Money funds resumed their growth in 1983, partly because they remained important to investors in their broader investment strategies. For example, brokerage houses include them as part of cash management accounts. In addition, mutual fund families offer money funds along with stock and bond funds as part of a menu of products that allows investors to switch between short- and long-term funds.

Stock and Bond Funds

In the 1980s, the growth of assets in stock and bond funds was driven by heavy purchases of fund shares, rising stock prices, and lower interest rates (rising bond prices). During this period, investment companies expanded the number and variety of long-term funds they offered. The development of new financial instruments, such as securities backed by mortgages or other assets, and the increased ease of investing overseas spurred the diversification of fund types. Funds investing in specific industries also became popular. The number of long-term funds increased from about 450 at the end of 1979 to about 3,300 by mid-1993.

Inflows to bond funds surged dramatically during the 1985-86 period (chart 3), with the majority of new money going to municipal, mortgage-backed, and government bond funds. Investors withdrew from bond funds in early 1987, when bond prices fell because of an upward move in interest rates; as deposit rates fell in relation to bond yields in late 1990, investors began moving aggressively into bond funds again. Stock mutual funds grew during the bull market of the mid-1980s 1980and then shrank in the aftermath of the stock market crash in October 1987. In 1989, with stock funds posting strong investment results, inflows resumed.

Retirement Assets

Some of the growth of mutual funds in the 1980s is attributable to their use as investment vehicles for retirement assets (chart 4). In 1982, U.S. tax laws created incentives for investors to open individual retirement accounts (IRAs) and Keogh accounts, which boosted investments in instruments, including mutual funds, that could be structured in the form of such accounts. The upward trend in the asset size of these retirement-oriented mutual fund accounts was interrupted in 1986, after the Congress enacted the Tax Reform Act of 1986, which reduced the number of households eligible to use IRA and Keogh accounts to defer taxes on current income.

In recent years, the share of mutual fund assets held by institutional retirement plans has increased. In addition, investments in IRA and Keogh mutual fund accounts have once again picked up with their use for lump sum distributions and rollovers from employee pension accounts that are liquidated because of a job change or plan termination.

Sales Loads and Fees

The growth and development of the industry has been associated with a decline in sales loads.(8) Among the mutual funds charging a front-end load, the average load fell from 8.5 percent in 1970 to about 4.5 percent in 1992.(9) Over the same period, the market share of no-load funds increased from 6 percent to about 31 percent of industry assets.

As sales loads have declined, expenses charged to shareholders, as a proportion of assets (the expense ratio), has increased substantially, except in the case of tax-exempt bond funds (table 2). The rise in expense ratios has occurred, however, at the same time that industry assets have been increasing, and insofar as many fund expenses are fixed costs, the growth in industry assets would reduce these ratios. Moreover, mutual funds operate in a competitive market, which impedes them from charging fees that exceed competitive levels.(10)

Three factors may have contributed to the rise in the industry expense ratio. Before 1980, a mutual fund's investment adviser and underwriter typically incurred the costs of distributing the fund's shares. In 1980, the SEC adopted rule 12b- 1, allowing mutual funds to use their assets to pay for sales commissions, sales literature, advertising, and other distribution expenses. Most no-load and low-load funds have adopted 12b-1 fees to finance their distribution expenses, and the fees have grown as a proportion of assets for funds imposing such fees (table 2).(11) Second, the number of small and international funds, which are more costly to operate, has grown. Third, mutual funds have expanded shareholder services that require costly computer, telephone, and shareholder accounting systems. These expenditures may have offset some of the gains achieved with economies of scale resulting from an increase in industry assets.

RECENT GROWTH OF THE INDUSTRY

Net sales of long-term mutual funds were a record $202 billion in 1992, up from $130 billion in 1991 and easily outpacing the previous record of $144 billion set in 1986 (chart 5).(12) During the first half of 1993, net sales amounted to $135 billion and at that rate will set another record.

One reason for the surge in net sales has been the drop in deposit rates to low levels by historical standards and the accompanying steepening of the yield curve. Although both short-term and long-term rates have fallen since 1989, the decline in short-term rates has been more pronounced. The rate on the six-month Treasury bill fell from 8.8 percent in the spring of 1989 to 3.2 percent in the summer of 1993, and the yield on the thirty-year Treasury bond fell from 8.7 percent to 6.3 percent over the same period. Thus, the returns on long-term assets, such as stock and bond funds, became increasingly attractive relative to rates on deposits at banks and thrift institutions, which follow short-term market rates. In addition, the heavy inflows in recent years may have been aided by the reduced need of depositories to compete aggressively for funds. For example, weak loan demand may have reduced the need of banks to offer competitive rates on deposits. Moreover, competition for funds may have been further reduced by the resolution of failed thrifts, which typically had paid a premium to attract funds.(13) As a result, deposit rates may have been lower than the given decline in market interest rates would have otherwise produced.

The strong net sales of mutual funds may also reflect the high yields that some mutual funds have been able to advertise. One way that a mutual fund differentiates itself and attempts to attract potential investors is to publicize its superior investing skills based upon past performance.(14) Advertisements will often highlight holding-period returns, calculated according to SEC guidelines, relative to some benchmark, such as returns on the issues in the S&P 500 index of stock prices or against other funds with similar investment objectives. Although such advertisements include disclaimers that past performance is no guide to future performance, they may still be effective in convincing investors that the fund has superior investment skills and is likely to enjoy superior future returns. Funds that have strong recent performance tend to have strong inflows, even though most research has failed to show that money managers can persistently produce superior returns.(15) Thus, some of the inflows to mutual funds may reflect the actions of investors who base their expectations of a fund's future returns on the fund's past performance.

The surge in purchases of shares in long-term funds is not unprecedented. In 1985 and 1986, investors shifted into bond funds when interest rates fell and the yield curve steepened. In fact, bond funds posted record net sales of $119 billion in 1986, slightly above the $115 billion of net sales in 1992 (chart 6). Inflows came to a halt in April 1987, when interest rates backed up sharply. Also during this period, the demand for bond funds for retirement purposes may have fallen when the Congress placed eligibility limitations on IRA contributions.

HOUSEHOLD OWNERSHIP OF MUTUAL FUNDS

The strong inflows to mutual funds reflect their popularity among households. According to preliminary data from the Federal Reserve Board's Survey of Consumer Finances, households shifted assets from deposits to mutual funds in the 1989-92 period; they held about 13 percent of their financial assets in long-term mutual funds at the end of 1992, up from about 10 percent in 1989, while their holdings of deposits and money funds fell from about 37 percent to 31 percent (table 3). Direct holdings of stocks, bonds, and "other" financial assets (not shown) also slightly increased during this period.(16)

The dispersal of ownership of long-term mutual funds also increased, from about 12 percent of households in 1989 to 15 1/2 percent in 1992. The increase in new ownership was most heavily concentrated among households in which the head was between 55 and 64 years of age. These households apparently shifted assets away from bank deposits and money funds into long-term mutual funds. Their holdings of bank deposits and money fund shares fell from about 40 percent of their financial assets in 1989 to about 22 percent in 1992, while the share of long-term mutual funds in their portfolios rose from about 11 percent to 17 percent over the same period. Somewhat in contrast, the households in the 35-44 age group maintained the share of their financial assets in bank deposits and money fund shares, at about 33 percent, over the 1989-92 period; the share of long-term funds in their portfolios did grow, however, from about 9 1/2 percent to about 121/2 percent, while the share of other financial assets declined.

MUTUAL FUNDS AS FINANCIAL INTERMEDIARIES

With their rapid growth, mutual funds have become increasingly important suppliers of debt and equity funds. Indeed, corporations with access to the reduced interest rates and elevated share prices of the capital markets have benefited from the surge in mutual fund assets: In recent years, mutual funds as a group have been the largest net purchaser of equities and a major purchaser of corporate bonds (table 4). Companies have repaid shorter-term debt--especially bank loans--and lowered the costs of long-term debt, while reducing overall balance sheet leverage. Such financial restructuring has been a particularly urgent priority for many of the firms that issued high-yield ("junk") bonds in the 1980s.

Mutual funds have been one of the major suppliers of credit in the high-yield bond market, as certain other institutional investors have pulled back from riskier investments. Recent legislation inhibits thrift institutions from investing in below-investment-grade corporate debt. And the public's concern about the financial health of life insurance companies has led most insurers to curtail their purchases of high-yield bonds and concentrate in high-grade securities. Consequently, flows to high-yield bond funds have played a more important role in the high-yield market than in the past, tending to boost bond prices (narrow yield spreads). Industry sources estimate that mutual funds, which purchased roughly 75 percent of new issuance of high-yield bonds in 1992, now hold about one-half of the stock of such bonds, up from about one-third in the 1980s.

Mutual funds also have increased their presence in the market for tax-exempt securities; they are now the largest net purchaser in that market (table 4) and are offsetting the reduced net purchases by households and the runoff at commercial banks. Banks have been net sellers of tax-exempt securities since passage of the Tax Reform Act of 1986, which significantly reduced the tax advantages for banks owning them. Households in the past several years have relied more heavily on mutual funds for their investments in municipal securities.

BANK-RELATED MUTUAL FUNDS

In response to the outflow of deposits, banks are increasingly participating in the mutual fund business through the advising of mutual funds and through the brokering of mutual fund shares. Banks and bank holding companies are prohibited from underwriting, distributing, or sponsoring mutual funds, according to interpretations of the Glass-Steagall Act of 1933 by the courts and federal regulatory agencies.(17)

Nevertheless, several rule changes have made it possible for banks to increase their participation in the industry.(18) In 1972, the Federal Reserve Board authorized bank holding companies to act as mutual fund investment advisers, transfer agents, and custodians.(19) In an accompanying interpretation, the Board placed several restrictions on the activities of bank holding companies that advise mutual funds. For example, neither a bank holding company nor its bank or nonbank affiliates could promote any mutual fund, or provide investment advice to any customer investing in any mutual fund, for which it acted as an investment adviser. In addition, the Board cautioned bank holding companies from advising a mutual fund, unless the fund was located off the bank's premises. In 1992, the Board relaxed some of these restrictions. Provided that a number of disclosures are made to customers regarding the bank holding company's relationship to the mutual fund and the status of mutual funds as an uninsured investment product, the Board allowed a bank holding company or its subsidiary to provide investment advice and other brokerage services to customers investing in any bank-advised fund. In addition, the Board eliminated the location restriction.

A banking organization can participate in the mutual funds industry in several ways. One is through a proprietary mutual fund (a fund advised by the bank), with the shares brokered by the bank primarily to its customers. An unaffiliated third party, however, organizes the fund and an unaffiliated distributor underwrites the shares. In addition, a bank can sell shares of nonproprietary funds, for which it acts only as broker. Involvement in the brokerage of these funds can range from renting lobby space to an unaffiliated broker to selling fund shares through a brokerage firm affiliated with the bank. Although the bank is providing only brokerage services, it does earn fee income from sales commissions and enters the retail mutual funds market at a low initial expense.

Net assets of bank proprietary mutual funds, including both long-term and money market funds, are estimated to have increased from $31 billion at the end of 1987 to $162 billion at the end of the first quarter of 1993 (table 5). Money market funds account for the majority of bank-related mutual fund assets, but bank-related long-term funds have grown rapidly in the past several years and are about evenly split between stock and bond funds. Between 1987 and early 1993, banks increased their market share of total industry assets from 4 percent to nearly 10 percent (table 5). However, they have had much greater penetration in the money fund sector than in the stock and bond sectors. At the end of the first quarter of 1993, bank money funds accounted for about 20 percent of total money fund assets, whereas bank long-term mutual funds were only about 4 percent of total stock and bond fund assets.

IMPLICATIONS FOR THE INTERMEDIATION PROCESS

By providing savers with investment options and by participating in the market for securities, mutual funds compete with other financial intermediaries. Although some intermediaries may have been adversely affected by the rise of such competition, mutual funds have tended to make the financial system more efficient by reducing the transactions costs to households seeking saving alternatives and to borrowers issuing securities.

Clearly, the growth of the mutual funds industry has challenged the traditional role of banks. Mutual funds pose a competitive threat by offering saving instruments that have become more attractive alternative to bank deposits, given their liquidity and other characteristics. Recent experience also suggests that households are quite sensitive to changes in returns on bank deposits relative to those on mutual fund shares. Mutual funds are aggressively attempting to exploit the greater household awareness by offering new types of funds, additional shareholder services, and retirement products.

Mutual funds also challenge banks to the extent that bank borrowers can directly tap the capital markets. As mutual funds grow, they make securities markets accessible to many borrowers that were previously confined to bank loans--medium-sized businesses and individuals, who gain indirect access to the public market through asset securitization.

As investors, mutual funds have played an important role in the development of markets for securitized financial assets. Securitization began with mortgages in the 1970s and has since spread to other types of financial assets, such as automobile loans and credit card receivables.(20) Banks and other nonbank institutions have increasingly securitized such assets and sold them to various investors, including mutual funds. Securitization allows banks and thrift institutions to continue to originate loans by having mutual funds and other investors fund such loans.(21) This form of intermediation thus complements lending by depository institutions but also produces greater competition in the provision of financial services.

Asset quality problems, higher regulatory capital requirements, and cautious lending also have added to the downward trend in the amount of intermediation through banks in recent years. Accompanying this diminished role for depository institutions in the credit markets has been the slow growth in broad measures of the money supply. Such slowness is reflected in the velocity of M2, which is the ratio of gross domestic product to M2. In the past, decreases in short-term interest rates have lowered the opportunity cost of holding deposits, as deposit rates typically lagged the decline in market yields, thus causing the level of M2 to rise relative to output and its velocity to fall. In the past three years, however, the velocity of M2 has risen in the face of the general decline in market interest rates.(22)

OUTLOOK

The mutual fund industry will remain an important investment option for household savings and an important funding source for corporations and state and local governments that can directly tap the capital markets. Growth of the industry may subside as the yield curve flattens and inflows into long-term stock and bond funds slows. However, the introduction of new types of funds and services, the potential for the growth of funds marketed through banks, and the demographic forces that favor retirement products will tend to support industry growth. (1.) Closed-end funds are well-suited for investment in less liquid securities, which may not be appropriate for the requirements of open-end mutual funds. In recent years, closed-end funds have been important purchasers of foreign stocks and bonds and of municipal bonds. (2.) The Securities and Exchange Commission has given money funds the authority to use either of two accounting techniques of share valuation: amortized cost and penny rounding methods. Under the amortized cost method, a money fund values its securities at historical cost, with any interest earned accrued daily over the life of the assets. By declaring these accruals as a daily dividend to its shareholders, the money fund is able to maintain a $1 price per share. Under the penny rounding method, a money fund rounds its net asset value per share to the nearest one cent to compute the current price of its shares. Most money funds use the amortized cost method of share valuation. (3.) Under the Investment Company Act of 1940, which establishes the legal and regulatory framework for the mutual funds industry, at least 40 percent of a fund's directors must be unaffiliated with the investment adviser, with any registered broker-dealer, or with any other interested person. (4.) About 59 percent of all sales of stock and bond fund shares in 1992 were brokered, (5.) Back-end loads, in contrast, are charges paid by investors only on redemptions that occur within a specified period after purchase, expressed typically as a percentage of redemption proceeds. Such loads, which usually decline over time, are used to recoup advances to brokers and to discourage trading by investors. (6.) SEC guidelines permit a mutual fund to hold up to 15 percent of its net assets in illiquid securities. (7.) For a detailed history, see Timothy Q. Cook and J. G. Duffield, "Money Market Mutual Funds and Other Short-Term Investment Pools," in Timothy Q. Cook and R. K. LaRoche, eds., Instruments of the Money Market, 7th ed. Federal Reserve Bank of Richmond, 1993), pp. 156-72. (8.) In the 1970 amendments to the Investment Company Act of 1940, the Congress authorized the National Association of Securities Dealers (NASD) to prescribe sales loads, subject to SEC oversight, and in 1975 the NASD adopted an 8.5 percent maximum on front-end sales loads. (9.) Back-end loads or contingent deferred sales loads (CDSL) are sometimes used in junction with 12b-1 fees as an alternative to front-end sales loads (12b-1 fees are those that can be assessed against fund assets to recover distribution expenses of the fund). For example, instead of charging a 6 percent front-end load, a mutual fund could recoup the same amount through a combination of an annual 1 percent 12b-1 fee and a CDSL of 6 percent that declines 1 percentage point per year until reaching zero after the sixth year. (10.) According to the antitrust criteria of the Department of Justice, an industry with a Herfindahl index of less than 1,000 is considered unconcentrated. For the mutual fund industry as a whole, the Herfindahl index ranged from 500 in 1984 to 380 in 1992.

The Herfindahl index is calculated as the sum of the squares of market shares of all fund complexes in the market. The larger the index, which can range from zero to 10,000, the more concentrated the market. (11.) In a rule that became effective in July 1993, the NASD limits the amount of 12b-1 fees that may be charged. The intent of the rule is to ensure that investors will not pay more than 7.25 percent of the purchase price of a mutual fund share when 12b-1 fees, front-end loads, and back-end loads are combined. Also, under the new rule, no fund that charges 12b-1 fees in excess of 0.25 percent can describe itself as a no-load fund. (12.) Net sales are gross sales plus reinvested dividends minus gross redemptions. Net sales of bond funds in 1992 were $115 billion, just under the record of $119 billion set in 1986. Net sales of stock funds were $87 billion in 1992, breaking the previous record of $46 billion set in 1991. (13.) As the Resolution Trust Corporation closed failed thrifts, it typically paid depositors directly and closed their accounts or sold the deposits to thrift institutions or banks that reset their rates, which in effect pushed average deposit rates down. (14.) See Erik R. Sirri and Peter Tufano, "Buying and Selling Mutual Funds: Flows, Performance, Fees, and Services," Harvard Business School Working Paper 93-017 (1992). They show that the demand for mutual funds is weakly related to fees charged and strongly related to services provided and past performance. (15.) See W. Sharpe, "Mutual Fund Performance," Journal of Business, vol. 39 (January 1966), pp. 119-38; M.C. Jensen, "The Performance of Mutual Funds in the Period 1945-1964," Journal of Finance, vol. 23 (May 1968), pp. 389-416; B. Lehmann and D. Modest, "Mutual fund Performance Evaluation: A Comparison of Benchmarks and Benchmark Comparisons," Journal of Finance, vol. 42 (June 1987), pp. 233-56; M. Grinblatt and S. Titman, "Mutual Fund Performance: An Analysis of Quarterly Portfolio Holdings," Journal of Business, vol. 62 (July 1989), pp. 393-416. (16.) "Other" financial assets include trusts, annuities, managed investment accounts, call accounts, deposits at uninsured institutions, and the cash value of life insurance. (17.) Investment Company Institute et al. v. Camp, Comptroller of the Currency, et al., 401 U.S. 617 (197 1). (18.) See Melanie L. Fein, Securities Activities of Banks (Prentice-Hall, 1992), for a detailed account of the regulatory changes. (19.) The Board's authorization was upheld by the Supreme Court against a challenge by the Investment Company Institute, the trade group for the mutual funds industry (Board of Governors of the Federal Reserve System v. Investment Company Institute, 450 U.S. 46 (1981). (20.) The securitization of loans to small and less credit-worthy firms has been rather limited. Thus, banks cannot easily originate and sell such loans into the secondary markets and have accordingly retained the business of these borrowers, who typically cannot directly tap the capital markets to obtain financing. Recent regulatory changes have made it easier for banks and other financial intermediaries to issue securities backed by small business loans in the public markets, but banks still need to evaluate and monitor the creditworthiness of such borrowers (21.) By securitizing, banks and thrift institutions save on capital costs, earn fee income from servicing the loans, and earn interest income from the spread between the borrowers' rate and the rate paid to the investors. (22.) See Bryon Higgins, "Policy Implications of Recent M2 Behavior," Federal Reserve Bank of Kansas City, Economic Review, Third Quarter 1992, pp. 21-36; and John V. Duca, "The Case of the Missing M2," Federal Reserve Bank of Dallas, Economic Review, Second Quarter 1992, pp. 1-24.