The Structure of Mutual Fund Charges

Mutual funds play an increasingly important role in financial intermediation. As of year end 1992, the U.S. mutual funds industry had more than $1.5 trillion under management in 3000+ funds. The popularity of mutual funds traditionally is attributed to the fact that they are professionally managed, small investors can achieve diversification generally available only to large investors, and that investors can take advantage of lower transaction costs, primarily in brokerage commissions. The author presents a model that considers three advantages of investing in mutual funds: (1) diversification benefits; (2) transaction cost savings due to brokerage discount on large trades; and (3) an investor's need for liquidity and the risk sharing benefits of investing in mutual funds. The model assumes two modes of access to the stock market: investment through a mutual fund or on personal account. The model is designed so that the trade-off between investing on personal account and investing in the mutual funds depends upon the trade-off between diversification benefits, transaction cost savings, and risk sharing advantages on one hand, and the fund charges on the other. The author shows that investment in mutual funds results in better allocation of the liquidity risk among the investors. The author show that investors who redeem their holdings in mutual funds impose a cost on those that do not. The mutual fund's expected profit increase as the probability of invest redemptions decrease because it becomes optimal for the mutual fund to hold more of the risky portfolio and less of the riskless assets in its portfolio. The model predicts that: (1) redemption rates are likely to be higher in funds without load fees; (2) closed end funds are likely to hold the least liquid assets, open end funds without load fees will hold the most liquid assets. The author also shows that mutual fund cash holdings increase with the volatility of redemptions. The results suggest that redemption fees may be more successful than front end load fees at curbing redemptions. And, aggressive growth funds are more sensitive to cash flows and are more likely to rely on load fees to dissuade redemptions because they hold more of the smaller, less liquid stocks. The author believes these results extend readily to other financial intermediaries. The model predicts that if pension funds and insurance companies are able to deter premature redemptions more successfully than are mutual funds, they will hold assets which are far less liquid that those held by mutual funds.