It Pays to Know How Your Money Is Managed

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This article is part of our Rising Star Portfolios Series.

Even if you have the proclivity to pick your own stocks (like me), chances are still decent that you or someone close to you has some sort of retirement or education account with mutual fund holdings. But have you ever thought about how that money gets managed?

Recently, Robert Pozen, Chairman Emeritus of MFS Investment Management and author of a new book The Fund Industry: How Your Money is Managed,spoke to us at Fool HQ about mutual funds, their history, and where he thinks money management may be headed.

In the beginning
Mutual funds first took hold in the U.S. back in the 1920s. The stock market crash of 1929 put a crimp in the industry's growth, but around the 1950s, investor confidence started to return, and mutual funds regained their popularity. Today, there are tens of thousands of mutual funds around the world, with more than $20 trillion in assets.

So what are some of the advantages to investing in mutual funds? According to Pozen, mutual funds offer:

  • Greater diversification to more securities through one fund.
  • Daily liquidity in buying and selling shares of the fund.
  • Professional management by licensed investors trained in asset management.
  • Better access to investment opportunities that might not exist otherwise.
  • Investor protections in a regulated environment.

However, funds aren't all sunshine and lollipops. Their disadvantages include

  • Fees for opening the account and investing in the fund.
  • No control on the timing of gains, since the individual is not buying and selling the assets in the fund.
  • Less predictable income, since investors have no control over dividend and interest income.
  • No customization. The fund is the same for everyone -- you get what you get, and if you don't like it, tough cookies.

Where do we go from here?
Thanks to increases in population, technology, and globalization, the mutual fund industry today is not only huge, but also fluid. With low barriers to entry, the fund industry sees many new entrants on a constant basis. Over time, many of these players either continue to stay small or eventually fade away altogether. However, some successful funds eventually reach a "tipping point," as Pozen describes it, where they ultimately need to go full-service, offering a variety of funds and investment vehicles to satisfy a broad reach of investors.

Today, dedicated asset managers Fidelity, Vanguard, and Capital Research represent the industry's top three asset-gatherers. They focus solely on managing the assets of their clients, and doing it well. Pozen considers this a superior model compared to the "financial supermarket" approach, where a firm offers a broad range of services such as stocks, insurance, and real-estate services. Over time, these supermarkets have become unviable, bogged down by regulatory scrutiny and investor demand for the best funds, regardless of the manager.

Going forward Pozen thinks the hybrid public-private model of dedicated asset management organizations controlled by investment professionals will be the most successful. Companies like BlackRock (NYSE: BLK  ) and Legg Mason (NYSE: LM  ) offer investors the best of both worlds: They are controlled by management (typically with skin in the game), and they tend to implement a long-term investor culture while maintaining currency for acquisitions to grow assets under management.

A mutually beneficial conclusion
The bottom line to all of this is that mutual funds are not just a one-size-fits-all gig. There are all sorts of ways to play them, and knowing what you're getting, just as with individual stocks, is an integral part of the process. There are more than 7,000 mutual funds available today for U.S. investors to sift through. Knowing how they are managed will give you an edge when you're ready to take the plunge.

Stock Advisor analyst Jason Moser owns no shares of any companies mentioned. Motley Fool newsletter services have recommended buying shares of BlackRock. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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