SECTION TWO:
Recent Mutual Fund Trends

SECTION THREE:
Mutual Fund Fees and Expenses

SECTION FIVE:
Mutual Funds in the Retirement and Education Savings Markets

SECTION SIX:
Where Investors Purchase Fund Shares

The U.S. mutual fund market is the largest in the world, accounting for half of the $16.2 trillion in mutual fund assets reported worldwide. In 2004, U.S. mutual fund assets reached a record $8.1 trillion.

This section examines:

investor demand for U.S. mutual funds in 2004, including the market factors affecting demand;
the prominent role of long-term mutual funds, in particular stock funds, in the U.S. mutual fund market; and
investor demand for bond and money market funds.

Investor Demand for Mutual Funds

The market environment for mutual fund investing remained very good in 2004. Investor demand for funds was supported by a robust U.S. economy, which, in 2004, grew at its fastest pace in five years and lifted U.S. corporate profits by 16 percent to a record $1.2 trillion. As the economic recovery showed greater strength in 2004, the Federal Reserve began to increase short-term interest rates in the middle of the year to forestall a significant rise in inflation. Longer-term interest rates moved in a fairly narrow range, despite the increase in short-term interest rates.

Distribution of Worldwide Mutual Fund Assets by Region, 2004

(percent of total assets)

Note: See Data Tables 44 and 45 for more worldwide data or visit Mutual Fund Statistics section of this website. Download an Excel file of this data.
Sources: European Fund and Asset Management Association, Investment Company Institute, and other national fund associations

In this market climate, investors allocated more assets to mutual funds holding stocks. Net new cash flow to stock and hybrid funds was $221 billion in 2004. Investors also reinvested $42 billion of dividends in their stock and hybrid funds. Investors redeemed a small portion of their bond fund holdings, perhaps on the expectations that potentially higher interest rates could erode near-term bond returns. Low short-term interest rates continued to result in outflows from money market funds, both from individual and institutional accounts.

For detailed data on inflows to stock, bond, and hybrid funds, see Section 3 in the Data Tables.

Individual Investors and Long-Term Investing

Individual investors, directly or indirectly, hold 90 percent of overall U.S. mutual fund assets, and an even larger share of stock, bond, and hybrid fund assets. In 2004, individuals continued to use funds as one of their primary means to invest. For example, households made $360 billion in net purchases of stocks, bonds, and other long-term financial assets during the year, and long-term mutual funds were the principal means of making these purchases. In addition, households held nearly 20 percent of their $37 trillion in financial assets-which excludes tangible assets such as homes and land-through mutual funds.

Mutual Funds’ Share of Household Financial Assets, 1990–2004

(percent)

Note: includes mutual funds held through employer-sponsored retirement plans, bank personal trusts, and variable annuities
Download an Excel file of this data.
Sources: Investment Company Institute and Federal Reserve Board

Households also hold a large portion of their financial assets (25 percent) in direct holdings of stocks, bonds, and other securities. These securities are typically held in accounts managed by private money managers, brokerage firms, and bank trust departments. Defined benefit plans and other pension funds (17 percent), banks and savings associations (13 percent), and life insurance companies (6 percent) managed significant portions of household assets in 2004.

Demand for Long-Term Mutual Funds

U.S. households' growing reliance on stock, bond, and hybrid mutual funds in part reflects many investors' desire to use funds to meet long-term investment goals such as preparing for retirement. Investor demand for long-term mutual funds-after a lull earlier this decade-has strengthened since early 2003, with net new cash flow to long-term funds totaling $475 billion between January 2003 and February 2005. Investors also reinvested another $152 billion in dividends during this period.

U.S. and Foreign Stock Market Investing

Investors added $178 billion of net new money to stock funds in 2004, the largest annual net inflow since 2000. Investor demand was particularly strong early in the year following the robust gains in U.S. and foreign stock markets in 2003. Demand for stock funds receded during the middle part of the year as the stock market flattened. It picked up again late in the year when worldwide stock markets made sizeable gains.

Stock funds primarily holding shares of U.S. corporations attracted $111 billion in new cash. Funds investing in foreign companies had strong inflows as well. The demand for these funds reflected the strong performance of many foreign markets during 2004. U.S. investors received a further gain on their foreign stock holdings with the increase in foreign currencies relative to the dollar, which lifted the dollar value of these securities.

Net New Cash Flow to Equity Funds, Wilshire 5000 Index, January 2000–February 2005

Note: Download an Excel file with data points on this chart. For more statistics, see the Data Tables in this book and the Statistics and Research section of this site.
Sources: Investment Company Institute and Wilshire Associates

Investor demand for hybrid funds, which invest in a combination of stocks and bonds, also picked up in 2004, with investors adding $43 billion in new cash to these funds. Investor demand for these funds had waned during the long rise in stock prices in the second half of the 1990s. However, in the aftermath of the 2000-2002 bear market in stocks and the accompanying decline in interest rates, investor interest in hybrid funds gained strength.

Understanding Turnover Rates for Stock Funds

All mutual funds buy and sell securities, and they do so for a variety of reasons. Managers of index funds buy and sell securities to reflect changes in the stocks tracked by the indexes. Managers of actively managed funds trade securities in order to implement their funds’ investment strategies. Managers of index and actively managed funds alike also buy and sell securities to accommodate the ebb and flow of “investable” dollars, as investors take advantage of an important mutual fund feature: the ability to purchase and redeem fund shares on demand.

Simple-Average Turnover Rate.

There are more than 4,500 stock funds offered in the United States. To determine the average or typical fund’s turnover rate, analysts must use some type of averaging technique to summarize the turnover rate of these funds. A “simple average” is an averaging technique that treats each fund equally in the calculation. Such an approach works well if the items being averaged—in this case the turnover rate of each stock fund—exhibit the standard textbook “bell-shaped” curve, with roughly an equal number of observations above and below the simple average, and with few observations that are very far from that average.

Turnover rates of funds do not fit this pattern, however, and the simple average is not the most accurate depiction of a typical fund’s portfolio turnover. For example, nearly three-quarters of all stock funds had a turnover rate below the simple average in 2004.

Simple Average and Median Stock Fund Turnover Rates, 1984–2004

(percent)

*preliminary data
Note: Download an Excel file with data points on this chart.
Sources: Investment Company Institute and © CRSP University of Chicago, used with permission, all rights reserved (773.702.7467/www.crsp.com)

Median Turnover Rate.

An alternative to the simple average—the median turnover rate—is a more accurate depiction of the turnover behavior of stock funds. The median turnover rate is the rate at which half of all stock funds have a turnover rate above the median and half have a turnover rate below the median. Unlike the simple-average turnover rate, the median does not overemphasize the turnover rate of a small number of funds.

The median turnover rate has not shown any pronounced increase or decrease during the past two decades. Removing index funds, some of which have very low turnover rates, does not change the underlying trend in stock fund turnover rates during the past two decades.

Asset-Weighted Turnover Rate.

To analyze the turnover rate that shareholders actually experience in their funds, it is important to identify those stock funds in which shareholders are most heavily invested. Neither the simple average nor the median provides any indication of the turnover actually experienced by mutual fund investors because they do not take into account where stock fund assets are concentrated. For this purpose, a more appropriate measure is an “asset-weighted” average. This calculation gives more weight to funds with large amounts of assets and, accordingly, indicates the average portfolio turnover actually experienced by fund shareholders.

In 2004, the asset-weighted turnover rate for stocks funds was 50 percent. Two-thirds of stock fund assets were in funds with portfolio turnover rates under 50 percent. This reflects shareholders’ tendency to own funds with below-average turnover and the propensity for funds with below-average turnover to attract more shareholder dollars.

Annual Turnover Rate Experienced by Stock Fund Investors, 1984–2004

(percent)

*preliminary data
Download an Excel file of this data.
Sources: Investment Company Institute and © CRSP University of Chicago, used with permission, all rights reserved (773.702.7467/www.crsp.com)

Mutual Fund Capital Gain Distributions

Capital gain distributions represent a fund’s net gains, if any, from the sale of securities held in its portfolio for more than one year. When gains from these sales exceed losses, they are distributed to fund shareholders.

Mutual funds distributed $55 billion in capital gains to shareholders in 2004. About 55 percent of these distributions were paid to tax-deferred household accounts, and another 40 percent were paid to taxable household accounts. Stock, bond, and hybrid funds can distribute capital gains, but stock funds typically distribute most of the gains. In 2004, 23 percent of stock fund share classes made a capital gain distribution, and these share classes distributed an average of 1 percent of their assets as capital gains.

For background information on funds and taxation, see Appendix A: Funds and Taxation. ICI also devotes a section of this website to tax issues.

Capital Gain Distributions Paid by Mutual Funds, 1996–2004

(billions of dollars)

*Households are defined to exclude mutual fund assets attributed to business corporations, financial institutions, nonprofit organizations, and other institutional investors.
Note: Components may not add to totals because of rounding.
Download an Excel file of this data.

Investor Demand for Bond and Money Market Funds

The U.S. interest rate environment plays a prominent role in the demand for fixed-income mutual fund shares from year to year: short- and long-term interest rate movements can result in significant ebbs and flows in individual and institutional investor purchases and redemptions of bond and money market funds.

Factors Affecting Demand for Bond Funds

Bond fund assets rose to $1.3 trillion in 2004, with fund performance accounting for the slight growth in assets. Investor demand for these funds weakened following three years of strong purchases. Cash flow into bond funds is highly correlated with the performance of bonds. Falling interest rates from 2001 through 2003 caused bond prices to rise substantially, producing strong bond fund returns. Interest rates on most bonds moved in a narrow range in 2004, and the boost in bond fund returns from rising bond prices was eliminated, leaving interest income as the principal source of performance for many bond funds.

Bond Returns and Net New Cash Flow to Bond Funds, January 1990–February 2005

1The total return on bonds is measured as the year-over-year change in the Citigroup Broad Investment Grade Bond Index.
2Net new cash flow to bond funds is plotted as a three-month moving average of net new cash flow as a percentage of previous month-end assets. The data exclude flows to high-yield bond funds.
Note: Download an Excel file with data points on this chart. For more statistics, see the Data Tables in this book and the Statistics and Research section of this site.
Sources: Investment Company Institute and Citigroup

Investor demand for bond funds also depends on the type of bonds that a fund holds. Funds investing in Treasury securities and tax-exempt bonds had outflows in 2004, while funds holding investment-grade corporate bonds continued to receive net new cash inflows.

Factors Affecting Demand for Money Market Funds

Money market funds have had net outflows since 2002 totaling $462 billion, as both households and institutions shifted short-term assets out of money market funds and into bank deposits and other competing investment options. The shift resulted from the low interest rates that prevailed following the Federal Reserve interest rate reductions, which reduced interest rates on money market securities to their lowest level in more than 40 years.

Net New Cash Flow to Money Market Funds, 1990–2004

(billions of dollars)

For more statistics on money market funds, see Section 4 in the Data Tables and the Statistics and Research section of this site. Download an Excel file of this data.

In this environment, interest rates paid on bank deposits were at or above those offered on money market funds, removing the yield premium that money market funds traditionally pay to investors in comparison to other short-term investment options.

Retail and Institutional Money Market Funds

Retail money market funds, which are principally sold to individual investors, had net outflows totaling $89 billion in 2004. Many retail money funds waived a portion of their fees in order to remain competitive with bank deposits. Nevertheless, yields on bank savings accounts were near money fund yields for much of the year, and households continued to move their short-term assets into bank deposits, adding more than $500 billion to bank accounts in 2004.

Interest Rate Spread and Net New Cash Flow to Taxable Retail Money Market Funds, January 1990-February 2005

(percent)

¹The interest rate spread is the difference between the taxable retail money market fund yield and the average interest rate on money market deposit accounts.
²Net new cash flow is measured as a percent of previous month-end taxable retail money market fund assets and is shown as a six-month moving average.
Note: Download an Excel file with data points on this chart. For more statistics, see the Data Tables in this book and the Statistics and Research section of this site.
Sources: Investment Company Institute, iMoneyNet, and Bank Rate Monitor

Institutional money market funds, used by businesses, pension funds, state and local governments, and other large investors, had outflows of $68 billion in 2004. Since 2002, businesses and other institutional investors have reduced their reliance on money market mutual funds for cash management purposes. U. S. businesses now hold about 21 percent of their short-term assets in money funds. This is down from the peak in 2002, but still above the levels in the late 1990s. The reason that the share rose earlier this decade is that falling interest rates temporarily boosted returns on money market mutual funds relative to other short-term investments, including direct investments in open-market securities. As money market fund yields returned to their normal relationship with market rates much of the new cash left money funds, and the portion of short-term business assets held through money market funds returned to a level in line with the 15-year upward trend.

During the second half of 2004, and into 2005, the Federal Reserve began to increase its target rate at a measured pace. Spreads began to widen on money funds relative to bank deposits, and the outflows from money market funds began to abate. This pattern of rising short-term interest rates, widening money market fund spreads relative to bank deposits, and outflows slowing and eventually turning to inflows is a pattern that has been in place for the past 20 years.

Share of U.S. Business Short-Term Assets* Held Through Money Market Funds, 1990-2004

(percent)

*Business short-term assets consist of foreign deposits, checkable deposits, time and savings deposits, money market funds, repurchase agreements, and commercial paper.
Download an Excel file of this data.
Sources: Investment Company Institute and Federal Reserve Board

Mutual Fund Dividend Distributions

Mutual funds distributed $117 billion in dividends in 2004. Dividend distributions come primarily from the interest and dividends earned by securities in a fund’s portfolio and net short-term gains, if any, after expenses are paid by the fund. Mutual fund dividends were boosted in 2004 by higher interest rates during the second half of the year and by an increase in corporate stock dividends. Bond and money market funds accounted for about 60 percent of all dividend distributions in 2004. More than half of dividend distributions were paid to tax-exempt and tax-deferred household accounts. Another 38 percent were paid to taxable household accounts.

For background information on funds and taxation, See Appendix A: Funds and Taxation in this book. ICI also devotes a section of this website to tax issues.

Dividend Distributions Paid by Mutual Funds, 1996–2004

(billions of dollars)

For more complete data on money market funds, see Section 4 in the Data Tables and the Statistics and Research section of this site.