Where Main Street Meets Wall Street
Its phenomenal growth, based on its near-perfect fit with consumer needs and aspirations, has made the mutual fund one of this century's big success stories. How is it adapting to the age of the Internet and 21st century change? HBS Professors Jay O. Light and Peter Tufano and three alumni take a look at the state of the mutual fund industry 75 years after its beginnings in Boston's financial district.
For Boston, whose history is better known for its midnight rides and tea parties with attitude, this was, by comparison, a low-key moment. On a slow July day in 1924 in the Hub's financial district, a new investment product was quietly put on the market. It was an inauspicious debut, but over the years, the mutual fund would shake up established norms of wealth creation and distribution in the United States. Indeed, it would help reshape America by uniting Wall Street and Main Street, two disparate worlds that previously had shared little more than a mutual suspicion of each other. Today, 75 years later, both camps benefit enormously from their close ties: the mutual fund is America's investment vehicle of choice, with one in three U.S. households owning a stake in the industry's $5.5 trillion in assets.
"By making the capital markets easily accessible to ordinary citizens, mutual funds have made an important contribution to both the democratization and the strengthening of the American economy," says HBS professor Jay O. Light, an expert on the financial services industry. And now, according to Light and other observers, that "democratization" of capital may be on the verge of another significant advance. For if the mutual fund first empowered the "little guy" by encouraging him to visit Wall Street, the Internet has captured the Street and placed it at his disposal, inside his personal computer.
A nation of investors
Earlier in this century, participation by everyday folk in the capital markets was all but unheard of; Wall Street remained an exclusive investment preserve (some would say playground) for America's financial elite. But by making the ownership of securities easy and affordable for people of modest means, mutual funds would over time turn even blue-collar workers into capitalists, and Americans-historically passbook savers-into a nation of investors.
"For the general public," notes John J. Brennan (MBA '80), chairman and CEO of the Vanguard Group, one of America's largest mutual fund companies, "mutual funds offer a level of professional investment management capability and skills once reserved for institutions or wealthy individuals. They provide a strong incentive to save and invest and have been a great source of wealth accumulation for individuals. Mutual funds also represent an important pool of capital for startups and established companies."
C. Bruce Johnstone (MBA '66), managing director of Fidelity Investments, the Boston-based mutual fund giant, observes that mutual funds have played a significant role as the middleman that makes capitalism work. "They are a key reason that our capital markets—the envy of the world—are so liquid and effective," he says. "Mutual funds deepen the capital markets, and the capital markets lubricate our entire economy by allocating financial resources."
For the consumer, the mutual fund combines a number of attractions in a single, highly value-added package: the marketability of its instantly redeemable shares, affordability, oversight by professional investors, asset diversification, and diminished risk. With these consumer-oriented advantages, with the flourishing postwar American economy, and with the industry's own aggressive marketing campaigns, the modern mutual fund (earlier versions were attempted in 19th-century Europe) has enjoyed truly phenomenal growth.
Almost from the outset, HBS has played a pivotal role in the success of this thriving industry. Says Jay Light, who holds the Dwight P. Robinson, Jr. Professorship of Business Administration, "HBS alumni were directly involved in establishing the modern mutual fund industry and continue in prominent leadership positions today. Much like management consulting and venture capital, it's an industry that really owes its development and success to HBS alumni." As it happens, Light's chair honors an industry pioneer from the 1950s to 1960s (an era that Light identifies as the "first burst" of success for the mutual fund). During those years, Dwight P. Robinson, Jr. (MBA '25) led the Massachusetts Investors Trust, the Boston firm credited with creating the first mutual fund in 1924. (In 1959, Robinson was featured on the cover of Time, with the magazine proclaiming, perhaps somewhat prematurely, that the mutual fund was "a household word.")
Historically, the mutual fund industry's fortunes have risen and fallen with the stock market. After the Crash of 1929, a new regimen of regulation was decreed for the financial services industry, with the 1940 Investment Company Act imposing especially tight controls on the nascent mutual fund industry. In recent years, Light says, besides benefiting from the bull market's record-setting rampage, the industry's asset growth has been driven by baby-boomers using mutual funds as a means to build their retirement nest eggs. A snapshot of some industry numbers reveals that in 1964, mutual fund assets totaled $28 billion; by 1980, they had grown to some $150 billion. But by 1992, assets had soared to $1.6 trillion, and by 1998, they had exploded to $5.5 trillion, a sum that surpasses the nation's bank deposits.
As the industry flourished, more and more financial services firms, offering a plethora of products, joined the fray. An expert on competition in the mutual fund industry, HBS professor Peter Tufano explains that with the industry's growth, competition intensified as well. "In the last fifteen years," Tufano says, "competition has centered on the most effective means of distributing products; on the quality, immediacy, and depth of information made available to consumers; and on the nature and variety of products being offered. Not surprisingly, competition has heightened activity and stimulated change in these areas." Tufano adds that the proliferation of information and products has been so enormous that a key area of competition has become the battle to simplify this overload and present it in manageable, user-friendly form to the consumer. In all these sectors of the industry, Tufano and the others agree, an increasingly important force is entering into the mix: the Internet.
The electronic brokerage
Still riding a "second burst" during the extended 1980s-1990s bull markets, the financial services industry, including the mutual fund sector, today is undergoing substantial transformation, thanks to the Internet's growing reach. Unlike other areas of Internet commerce, such as online bookstores, where the cost of merchandise is roughly equivalent to in-store prices, Jay Light underscores the significant cost differentials inherent in online trading. "The online consumer can execute a trade for up to 90 percent less than a traditional broker's fee," Light points out. "Consequently, the intermediaries in the financial services industry—the brokers—are really going to be affected. Having said that, however, I believe there will always be people who want personal interaction with a broker."
Much attention recently has centered on the Internet-enabled activities of online "day-traders"-do-it-yourselfers who buy and sell individual stocks daily, often holding them for just minutes at a time. Notes Bruce Johnstone, "Online traders have become a potent force and one that I believe is having an impact on mutual funds. Clearly some money that would have been destined for mutual funds is not coming in because a portion of the undecided investor population is choosing instead to try trading stocks online."
But for the most part, because committed mutual fund consumers are investors who hold portfolios of diversified securities and have long-term goals, they are less likely to engage in such frenetic trading. Instead, the Internet's real impact, according to Jay Light, will not be as an electronic trading mechanism but as a powerful new distribution channel-a way for mutual fund firms and online brokerages to interact easily and comprehensively with established and potential customers.
"E-commerce will certainly make it easier for individuals to buy and sell mutual funds," says Light. "But it will also move the money management organization even closer to the ultimate consumer, with extensive information, research, and thousands of mutual funds to choose from, all with a few keystrokes. It's already happening."
Of course, the Internet tidal wave affects not only customers but companies, too, and perhaps more profoundly. A case in point is the firm that is known as the leading online brokerage, Charles Schwab & Company, based in San Francisco. Randy W. Goldman (MBA '76), vice president for electronic brokerage product development at Schwab, explains that her company's Internet site carries more than half the firm's trading volume and handles some $4 billion in securities transactions per week. A few years ago, online transactions were nonexistent at Schwab.
But just as significant as the explosion of its Internet trading revenues, Goldman says, may be the Web-driven strategic changes at Schwab. With the company originally conceived as an alternative to traditional brokerages, Schwab's breakthrough, Goldman asserts, was to understand the Internet as more than just a new tool for fine-tuning its original specialization as a discounter.
"We've made the choice to compete in a much larger arena," Goldman says. "More than a discount transaction house, we're positioning ourselves to compete now as a full-service investment firm without charging the hefty commissions that 'full service' usually implies. Our online presence is just part of a larger operation designed to help customers achieve their long-term financial objectives through an array of services, products, and coordination between the Web, the phones, and our service centers. We let people pick the service they're comfortable with, including face-to-face advice."
Fidelity's Bruce Johnstone says his firm is very much a Web presence. "We have the second-largest discount brokerage in the United States, and more than half our brokerage trade is done online," he points out. "Our brokerage division also acts as a distribution arm for our mutual funds, so it has a dual online role: trading individual securities and distributing mutual fund product over the Net."
Vanguard's John Brennan believes that "the Internet is going to have a tremendous effect on the mutual fund industry and its investors. It will make everything easier, less expensive, and more comprehensive for consumers." For fund companies, Brennan believes, the competitive advantage lies with who best uses the Internet's immediacy and wealth of information to educate and advise the consumer. "It all adds up to a real boon for consumers," he notes. "At our Web site, for example, we have posted financial planning information that not so long ago probably would have cost a consumer thousands of dollars."
Into the future
With so much of Wall Street inside personal computers, consumer empowerment—and the democratization of financial services—has reached a significant new level. The Web's interactivity and ability to deliver incredible amounts of timely information and to perform transactions quickly and economically have spurred organizational and strategic transformation. Customers' expectations and demands are escalating, as well. As Schwab's Goldman says, "What people expect and what brokers are willing to provide for nothing are both increasing. The more you give for free, the more consumers expect to get for free."
And with consumer expectations high, the already crowded and competitive mutual fund industry—with more than seven thousand funds currently offered—faces a future in which the strong stock market, and the favorable demographics that have boosted it, will inevitably lose steam. What then?
"We've seen a tremendous amount of creativity in the financial services industry, including the mutual fund sector, so I have no doubt that there will continue to be product and process innovations sufficient to meet changing conditions," Peter Tufano observes. For his part, Fidelity's Johnstone remains bullish about the investment management industry. He sees the currently favorable investment climate, helped by baby-boomer demographics, continuing well into the next decade. He further notes the potential for positive new developments, such as the congressional proposal to augment the Social Security system with a program of private savings, a plan that presumably would include the mutual fund industry.
Ultimately, it is the fundamentals upon which the mutual fund industry has been developed that will carry the business into the future, declares Vanguard's Brennan, who also currently serves as chairman of the industry's national association, the Investment Company Institute. "Change will not alter our industry's foundation, which consists of assets such as prudence, diversification, a long-term investment philosophy, reliability, and consumer trust," says Brennan. "At Vanguard, and I'm sure at other firms as well, our goal is to listen closely to our clients' changing needs. If we do that and execute well, I believe we'll be successful in any investment environment."
From "Where Main Street Meets Wall Street: America and the Rise of the Mutual Fund" Harvard Business School Bulletin, June 1999.