Bob Pozen is a man who knows his way around the mutual fund industry. Just ask Presidents Obama and Bush, the SEC, Harvard Business School and the Massachusetts voters who have urged him to run for the U.S. Senate, not to mention mutual fund firms including Fidelity Investments and MFS Investment Management.
Now, the mutual funds guru and author of Too Big To Save? How to Fix the U.S. Financial System is co-author of the painstakingly detailed The Fund Industry: How Your Money Is Managed. Indeed, Pozen and co-author Theresa Hamacher’s examination of how mutual funds are bought, sold and managed is so comprehensive that it stands to become the fund industry’s bible.
"Just as veteran stock fund managers prize their tattered copies of Ben Graham and David Dodd's Security Analysis, coming generations of fund industry leaders will cling to this essential text,” writes Morningstar Managing Director Don Phillips in the new book’s foreword. “There's no other book that gives readers such a thorough overview of how the fund industry operates, its evolution, its regulation and what makes it tick."
In addition to being a recently published author, Pozen (left) is chairman emeritus of MFS, which in 1924 established America’s first open-end mutual fund, the Massachusetts Investors Trust. He is also a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. And before his tenure at MFS, Pozen was vice chairman of Fidelity Investments.
Want more proof of his expertise? Pozen has served as chairman of the Securities and Exchange Commission's Advisory Committee on Improvements to Financial Reporting. And in 2001 and 2002, he was a member of President Bush’s Commission to Strengthen Social Security. His plan to save Social Security was included in a series of memoranda to President Obama from the Progressive Policy Institute.
A Democrat, Pozen recently told Reuters that he wouldn’t run for Senate “unless the Democratic Party asks me to, if they want someone who is socially liberal and fiscally disciplined.” But if the party wants a confrontational figure to take on Republican Sen. Scott Brown next year, Pozen added, “then they shouldn’t choose me because I won’t be that type of candidate.”
In a conversation on Thursday with AdvisorOne, Pozen didn’t address his political ambitions, but he did speak at length about the mutual fund industry in relation to the Dodd-Frank financial reform act, changes in regulation of investment advisors, U.S. retirement planning and the global economy.
“People are investing huge sums in the fund industry. We have $11 trillion in this,” he said in explanation of why he decided to write his book now. “If people don’t understand how their money is being managed, they could become very unhappy about what’s happening.”
Q: How did this book come about? Why did you and Theresa Hamacher write The Fund Industry?
A: In 2001, I wrote a book called The Mutual Fund Business, which was geared to investors. At the same time, the National Investment Company Services Association (NICSA), the trade association for back offices that Theresa is head of, had commissioned somebody to do a nuts-and-bolts book on mutual funds for back-office service providers.
Those books were successful within limits, each selling between 5,000 and 10,000 copies, and both are now out of date. Theresa and I know each other, and we thought what we really ought to do was to combine them into one book. We thought we could work together well, and we did. The really important thing is that she has a wonderfully light touch as a writer, and I tend to be heavily analytical, so it was a great partnership.
Q: Who is your intended audience?
A: We have three different audiences. The most important one is investors, because there are close to 100 million investors in mutual funds, and a large number of them know relatively little about their funds. They may just know a fund’s return for the last year. Our attempt here is to write something to help investors be better informed about choosing funds and understanding their performance. For example, Chapter 3 is dedicated to explaining the disclosure documents that come from the fund complex. How many people actually read a fund prospectus? The answer is almost no one. Our chapter looks at what investors really need to look at in terms of the riskiness of a fund. We’re giving focus on how to handle the flood of information.
The second audience is the industry, meaning all the people who work in the industry and the people who service the industry, and I’m including custodian banks, accounting firms, law firms, journalists and new people manning the phones for a company like Vanguard. This is pretty much going to be the bible for all of these industry people. It has a tremendous amount of detail about how you compute loads, how 12-b funds work, how fair-value pricing works and so on. This is a source book. If an issue comes up about whether a fund is fooling around with its NAV, we tell you how NAV is calculated and whether you’re allowed to have adjustments.
The third audience is universities and business schools. We have a website, and I’ve written a manual for people teaching the course at universities or business schools or training in the fund complex. It also includes about 14 case studies that I’ve written for the Harvard Business School as well as assignment questions, a teaching plan and the answers.
Q: What does your book have to say about retirement planning?
A: We have a whole chapter explaining what happens in retirement. You may not understand the tax features of retirement plans and how they operate. What’s the difference between DB and DC plans? How do rollover IRAS work? We have millions of people in 401(k)s who actually know very little about those plans. I think they’ll do a lot better in terms of investing while they’re accumulating and also planning for their retirement if they understand the tax and investment issues.
For instance, we know that $500 million moved in 2009 and 2010 into high-quality Treasury and investment-grade bond funds. Most of those people will tell you they were doing something very conservative; they thought they were reducing risk. But a lot of them didn’t understand how much interest-rate risk they were taking. Half of retail investors don’t understand that if their interest rates go up, their bond funds go down in value. We have a whole primer on how bonds and bond funds work.
Q: With all the change in the financial services industry, do you plan to periodically revise this mutual funds “bible”?
A: As I said, we have a website for teachers, but we also have a separate website for general readers where we show things like what a prospectus looks like. If there are significant changes, we can talk about them on the website. Whether we will actually republish the book, the answer is that it would take a while. Historically, we’ve gone through one of the greatest financial changes we’ve ever seen in the years 2000 to 2010. I doubt we’ll have as much change in the next 10 years.
Q: Even up to the moment when the presses ran, were you still updating your book?
A: Yes, absolutely. We put the book to bed in August or September, and it came out on Feb. 9, so there were still some rules that were being adopted out of the Dodd-Frank bill that we had to update. Dodd-Frank’s main emphasis is on banks and derivatives, and not on mutual funds. Dodd-Frank has almost no effect on stock funds or bond funds.
There are three areas where there is significant change that we explain in the book. One is for investment advisors. It used to be the case that hedge fund managers did not have to register as investment advisors. Now under Dodd-Frank, they have to register. The second area involves advisors to retail customers. Dodd-Frank requires the SEC to “harmonize” brokerage reps and independent advisors, and those rules haven’t come out yet, but we explain what those differences are and where the legislation is trying to go. The third area we deal with is money market funds. Before Dodd-Frank, the SEC had already taken a number of moves to tighten the rules, and we include those.
Q: Tell me about the current state of retirement funds and the regulation of 401(k)s.
A: The big issue in retirement planning is how much choice participants want to have. I think it’s fair to say that in most plans you have a group of people who want a lot of choice and information and to carefully think out what they’re going to invest in. But there’s another group of people who are really not that interested in making those choices, and many of them say they like to save but they actually haven’t done much about it. Most companies have both of those two very different groups of people. We have a set of rules that the Labor Department has put forth for people who want to have many choices, and they get certain disclosures. The big change is that in 2006, Congress allowed automatic enrollment with opt-out. That’s fully increasing the participation rates in plans, especially for low-income and minority workers.
Q: What do you think about target date funds?
A: When you have automatic enrollment with an opt-out, you’ve got to have a default option. There are still many people who come into the fund, and they don’t opt out, but they won’t actually choose the fund. The whole notion of automatic enrollment is that inertia works for you. Your employer will say to you, “You’re in this fund. You’re putting in 2% of your pay unless you opt out” and you do nothing, so you’re in the plan. But you’ve done nothing, so you haven’t made an investment choice.
That’s why we need a default option for all the people in these automatic enrollment plans who don’t opt out but also don’t fill out any paperwork and choose any fund. That’s the default option. A lot of employers have now used target date funds as their default option. Today, I just published an article in Ignites about why I think that target date funds are inferior to balanced funds.
[Editor’s note: In his op-ed for Ignites, The Financial Times’ proprietary mutual-fund website, Pozen writes: “The net returns of a balanced fund are likely to be higher than those of a target-date fund. It is impossible to predict over the 20 to 40 years of a worker's career when equity markets will do well. Thus, on an expected return of an investment performance basis, the expected returns of a balanced fund are roughly the same as the expected returns of a lifestyle fund. Yet the expenses of the lifestyle fund are always higher — in most cases, from 15 to 30 basis points higher per year — so its net returns are likely to be lower than those of a balanced fund.”]
Q: To conclude, please tell me about your book’s final section, which covers the internationalization of mutual funds.
A: Our general view is that most Americans are under-invested internationally. From a diversification point of view, half of the world’s market assets are outside of the United States, but it’s the rare U.S. individual who has half of his or her portfolio outside. When you think about it, your job is here, your house is here, etc. If you put half of your 401(k) internationally, you would actually have about 25% or 30% of your assets internationally. Your portfolio is one of the few ways you can do it.
We’re not saying you should be at half, but the average retail investor has something like 10% or 15% invested internationally. In our view, that’s much too low. Exactly how much should be invested internationally depends on your appetite for risk. We explain in Chapter 16 the special challenges, advantages and risks involved with international investing through funds, but the answer is that it should be a lot higher.
Read about Pozen’s work on the SEC’s financial reporting advisory committee at AdvisorOne.com.