The U.S. mutual fund market, with $10.4 trillion in assets under management as of year-end 2006, remains the largest in the world, accounting for 48 percent of the $21.8 trillion in mutual fund assets worldwide (Figure 2.1).

Investor demand for mutual funds is influenced by a variety of factors, not least of which is funds' ability to assist investors in achieving a wide variety of investment objectives. In particular, U.S. households' growing reliance on stock, bond, and hybrid mutual funds reflects investor desire to meet long-term personal financial objectives such as preparing for retirement. Furthermore, U.S. households, businesses, and other institutional investors use money market mutual funds as cash management tools because they provide a high degree of liquidity and competitive, short-term yields.

Investors' reactions to U.S. and worldwide economic and financial conditions also play an important role in determining demand for specific types of mutual funds and for mutual funds in general—from year to year and over longer periods.

Figure 2.1

U.S. Has the World's Largest Mutual Fund Market

(percent of total assets, 2006)

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Note: Components may not add to 100 percent because of rounding.
Sources: Investment Company Institute, European Fund and Asset Management Association, and other national fund associations

U.S. Mutual Fund Assets

Stock mutual funds accounted for about 57 percent of U.S. mutual fund assets by year-end 2006. This share has ranged from 50 to 60 percent since 1997, with the exception of 2002 when the share dropped to around 42 percent largely owing to the sharp decline in the U.S. stock markets that year. In 2006, domestic stock funds—those that invest primarily in shares of U.S. corporations—held 44 percent of total industry assets; international stock funds—those that invest primarily in foreign corporations—accounted for another 13 percent. Money market funds (23 percent), bond funds (14 percent), and hybrid funds (6 percent) also held sizable portions of total U.S. mutual fund assets.

Approximately 500 fund sponsors managed mutual fund assets in the United States in 2006. Competitive dynamics have prevented any single firm or group of firms from dominating the market. The share of assets managed by the largest 25 firms in 2006 has dropped to 71 percent from 78 percent of assets managed by the largest 25 firms in 1985 (Figure 2.2). In addition, the share of assets managed by the largest five firms in 2006 is comparable to the share managed by the largest five firms in 1985. Many firms have entered and exited the fund industry since the mid-1980s. For example, of the largest 25 fund complexes in 1985, only 14 remained in this top group in 2006.

Other measures also indicate that no one firm or group of firms dominates the mutual fund market. One such measure is the Herfindahl-Hirschman index, which weighs both the number and relative size of firms in the industry to measure competition. Index numbers below 1,000 indicate that an industry is unconcentrated. The mutual fund industry has a Herfindahl-Hirschman index number of about 400.

Figure 2.2

Share of Assets at Largest Mutual Fund Complexes

(percent of total industry assets, year-end, selected years)

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Developments in Mutual Fund Flows

Investor demand for mutual funds increased in 2006. Net new cash flow to all mutual funds—the dollar value of new fund sales minus redemptions, combined with net exchanges—was $474 billion, up from the pace of the previous four years and close to the record pace set in 2001 (Figure 2.3). Higher inflows to money market mutual funds and international stock funds accounted for much of the increase. U.S. short-term interest rates rose steadily in the first half of the year, as the Federal Reserve continued to tighten monetary policy in response to strong underlying growth in resource utilization in the economy and heightened concerns about inflationary pressures. In the second half of the year, the Federal Reserve held overnight rates steady, as the housing market cooled and economic activity moderated.

Abroad, many countries continued to experience economic growth exceeding that in the United States. In addition, foreign stock markets, especially those in emerging markets, continued to outperform U.S. stocks by a wide margin.

Figure 2.3

Inflows to Mutual Funds

(billions of dollars, 1992–2006)

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Mutual Fund Assets by Tax Status

Unlike most corporations, a mutual fund generally distributes all of its earnings—capital gains and ordinary dividends—each year to shareholders, and is taxed only on amounts it retains. Fund investors are ultimately responsible for paying tax on a fund's earnings, whether they receive the distributions in cash or reinvest them in additional fund shares. Investors often attempt to lessen the impact of taxes on their investments by investing in tax-exempt funds and tax-deferred retirement accounts. As of 2006, 7 percent of all mutual fund assets were held in tax-exempt funds and 46 percent were invested in tax-deferred accounts held by households (Figure 2.4).

For more information on tax issues affecting mutual fund shareholders, visit the Institute's website.

Figure 2.4

More Than Half of Mutual Fund Assets Held in Tax-Deferred Accounts and Tax-Exempt Funds

(percent, 2006)

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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. When gains from these sales exceed losses, they are distributed to fund shareholders. Mutual funds distributed $259 billion in capital gains to shareholders in 2006 (Figure 2.5). About 60 percent of these distributions were paid to tax-deferred household accounts, and another 34 percent were paid to taxable household accounts. Stock, bond, and hybrid funds can distribute capital gains, but stock funds typically account for the bulk of the distributions. In 2006, 46 percent of stock fund share classes made a capital gain distribution, and these share classes distributed an average of nearly 10 percent of their assets as capital gains.

Figure 2.5

Capital Gain Distributions

(billions of dollars, 1997–2006)

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Note: Components may not add to the total because of rounding.

Mutual Fund Dividend Distributions

Dividend distributions represent income—primarily from the interest and dividends earned by the securities in a fund's portfolio—after expenses are paid by the fund. Mutual funds distributed $241 billion in dividends to fund shareholders in 2006 (Figure 2.6). Mutual fund dividends were boosted by higher short-term interest rates and an increase in dividend payments by corporations. Bond and money market funds accounted for 67 percent of all dividend distributions in 2006. About 45 percent of all dividend distributions were paid to tax-exempt and tax-deferred household accounts. Another 40 percent were paid to taxable household accounts

Figure 2.6

Dividend Distributions

(billions of dollars, 1997–2006)

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Note: Components may not add to the total because of rounding.

Demand For Long-Term Mutual Funds

Investors added $227 billion in net new cash to stock, bond, and hybrid funds in 2006, maintaining the recent robust pace of inflows to these long-term mutual funds (Figure 2.7). Investor demand for long-term funds, which slowed largely in response to the broad-based decline in the stock market from mid-2000 to the end of 2002, began to strengthen in early 2003, and has been fairly steady since then at roughly a $200 billion annual rate. Between 2003 and 2006, net new cash to long-term funds totaled $845 billion. Moreover, during this same period, investors reinvested $358 billion in dividend distributions back into the funds.

No-load share classes of stock, bond, and hybrid mutual funds continued to receive the bulk of net new cash, attracting $166 billion of the total $227 billion in inflows in 2006 (Figure 2.7). Mutual fund sales to investors in employer-sponsored retirement plans account for a large portion of no-load fund sales. Also, no-load inflows likely were boosted by sales of funds of funds, which often invest in underlying no-load funds. Net new cash to load funds amounted to $37 billion. Front-load and level-load shares received more than the net total of $37 billion, while back-end load shares had net outflows for the fifth consecutive year.

Figure 2.7

Net New Cash Flow to Long-Term Funds by Load Structure

(billions of dollars, 2000–2006)

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1Front load › 1 percent. Primarily includes A shares; includes sales where front loads are waived.
2Front load = 0 percent and CDSL v 2 percent. Primarily includes B shares.
3Front load ≤ 1 percent, CDSL ≤ 2 percent, and 12b-1 › 0.25 percent. Primarily includes C shares; excludes institutional share classes.
4All other load share classes not classified as front load, back-end load, or level load. Primarily includes retirement share classes known as R shares.
5Front Load = 0 percent, CDSL = 0 percent, and 12b-1 ≤ 0.25 percent.
Note: Components may not add to the total because of rounding.
Sources: Investment Company Institute; Lipper; ValueLine Publishing, Inc.; CDA/Wiesenberger Investment Companies Service; © CRSP University of Chicago, used with permission, all rights reserved (312.263.6400/www.crsp.com); and Strategic Insight Simfund

Stock Funds

Investors added $160 billion of net new money to stock funds in 2006, somewhat above the pace of the previous year (Figure 2.8). Domestic stock funds attracted $11 billion in new cash, down from $31 billion the previous year. Since 2004, investors have significantly reduced their net purchases of domestic stock funds. Funds investing in foreign companies garnered a record $148 billion in new cash in 2006, up from $105 billion the previous year. The robust demand for these funds reflected, in part, the strong performance of many foreign stock markets, especially when compared with returns in the U.S. stock markets. From year-end 2004 to year-end 2006, total returns on U.S. equity indexes ranged from around 12 percent to about 21 percent, while those on world stock indexes (excluding U.S. stocks) were about 45 percent. Total returns on stocks traded on emerging markets were close to 77 percent over the same period.

Figure 2.8

Flows to Equity Funds Related to global Stock Price Performance

(1992–2006)

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1The return on equities is measured as the year-over-year change in the MSCI All Country World Index.
2Net new cash flow to equity funds is plotted as a six-month moving average.
Sources: Investment Company Institute and Morgan Stanley Capital International

Investors tend to own stock mutual funds with relatively low fees, expenses, and turnover rates. Mutual fund assets are heavily concentrated in funds with below-median expenses and below-average turnover. The turnover rate—the lesser of purchases or sales (excluding those of short-term assets) in a fund's portfolio scaled by average net assets—is a measure of a fund's trading activity. In 2006, the asset-weighted annual turnover rate experienced by stock fund investors remained steady at 47 percent, a fairly low rate when compared with the historical experience of the past 35 years (Figure 2.9).

Figure 2.9

Turnover Rate1 Experienced by Stock Fund Investors Remains Low2

(percent, 1972–2006)

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1asset-weighted average
2excludes variable annuities
Sources: Investment Company Institute; © CRSP University of Chicago, used with permission, all rights reserved (312.263.6400/www.crsp.com); and Strategic Insight Simfund

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

Bond and Hybrid Funds

In 2006, investors added $61 billion to their bond fund holdings, nearly double the pace of net investment in the previous year. Cash flow into bond funds is highly correlated with the performance of bonds (Figure 2.10). Traditionally, the U.S. interest rate environment has played a prominent role in the demand for bond funds. Movements in short- and long-term interest rates can significantly alter the returns offered by these types of funds and, in turn, influence retail and institutional investor demand for bond funds.

Figure 2.10

Flows to Bond Funds Related to Bond Returns

(1992–2006)

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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.
Sources: Investment Company Institute and Citigroup

Falling interest rates between 2001 and 2003 led to significant returns for bond funds, spurring investor demand. Since 2003, returns on intermediate- to long-term bonds have moderated, ranging from about 3 percent to 5 percent per year. As a result, money moved out of bond funds in 2004 and—based on the historical relationship between bond returns and demand for bond funds—one would have expected outflows to continue in 2005 and 2006. A factor that may have contributed to bond fund inflows over the past two years is the growing popularity of funds of funds. Net inflows to funds of funds totaled $181 billion from year-end 2004 to year-end 2006 and, likely, some portion of these flows was directed to the underlying bond mutual funds (Figure 2.11).

Investor demand for hybrid funds, which invest in a combination of stocks and bonds, waned in 2006, with investors adding only $7 billion in new cash to these funds. Over the three-year period 2003 to 2005, however, hybrid funds attracted a total of $100 billion in net new cash.

Funds of funds

Funds of funds are mutual funds that hold and invest in shares of other mutual funds. The most popular type of these funds is hybrid funds—nearly 80 percent of fund-of-fund assets are in hybrid funds of funds. Hybrid funds of funds invest their net new cash in underlying stock, bond, and hybrid mutual funds.

Assets of funds of funds have grown rapidly over the past decade. By the end of 2006, the number of funds of funds had grown to 604, and total assets reached $471 billion (Figure 2.11). About two-thirds of the increase in assets of funds of funds in the past 10 years is attributable to increasing investor interest in lifestyle and lifecycle funds. The growing popularity of these funds, especially for retirement investing, likely reflects the auto-rebalancing features of these products. Lifestyle funds, also known as risk-based funds, maintain a predetermined risk level, and lifecycle funds, also known as target date funds, allow a predetermined reallocation of risk over time. Since 1995, funds of funds received a total of $311 billion in net new cash, of which nearly 70 percent was from lifestyle and lifecycle funds.

Figure 2.11

Net Assets and net new Cash Flow to Funds of Funds

(1996–2006)

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1year-end
2annual

Demand for Money Market Mutual Funds

Net new cash flow to money market funds strengthened significantly in 2006, likely reflecting the elevated level of short-term interest rates.

Retail Money Market Funds

Retail money market funds, which are principally sold to individual investors, received net new cash of $96 billion in 2006, following a modest inflow of $2 billion the previous year (Figure 2.12). Money fund yields followed the pattern of short-term interest rates, rising steadily in the first half of 2006 then leveling off in the latter part of the year. The difference between yields on money market funds and those on bank deposits widened to almost 4 percentage points during 2006, the largest money fund yield premium since June 2000 (Figure 2.13). This relationship among rising short-term interest rates, the widening money market fund yield premium relative to bank deposits, and slowing outflows that eventually turn to inflows is a pattern observed over the past 20 years.

Figure 2.12

Flows to Money Market Funds Strongest in Several Years

(billions of dollars, 1992–2006)

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Figure 2.13

Flows to Taxable Retail Money Market Funds Related to Interest Rate Spread

(1992–2006)

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1Net new cash flow is a percent of previous month-end taxable retail money market fund assets and is shown as a six-month moving average.
2The interest rate spread is the difference between the taxable retail money market fund yield and the average interest rate on money market deposit accounts.
Sources: Investment Company Institute, iMoneyNet, and Bank Rate Monitor

Nevertheless, households have continued to invest in bank deposits more heavily than expected based on this historical relationship. In 2006, they added about $500 billion to their holdings of time and savings deposits, despite the wide premium offered on money market funds. Changes in brokerage firms' cash management policies for their retail accounts likely have contributed to the increased use of bank deposits by households. In recent years, brokerage firms increasingly have relied less on money market funds and more on bank money market deposit accounts as cash management accounts for their retail clients.

Institutional Money Market Funds

Institutional money market funds, used by businesses, pension funds, state and local governments, and other large investors, had inflows of $151 billion in 2006, following inflows of $61 billion the previous year (Figure 2.12). Some of this increase may reflect the diminished need for businesses to hold checking deposits at banks. Banks are prohibited by law from paying interest on demand deposits, but many institutional customers earn credits based on an implicit interest rate on their deposits. These credits can be used to pay for banking services. When interest rates decline, businesses often increase their checking deposits to earn sufficient credits to pay for their services. Over the period 2002 to 2004, nonfinancial businesses added about $80 billion to their checking accounts, and some of this additional cash likely came from money market funds. During 2005 and 2006, conversely, nonfinancial businesses shifted a total of about $70 billion out of checking deposits, with some of this cash likely invested in money market funds. U.S. nonfinancial businesses held 27 percent of their short-term assets in money market funds as of year-end 2006 (Figure 2.14).

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

Figure 2.14

Money Market Mutual Funds Managed 27 Percent of U.S. Businesses' Short-Term Assets* in 2006

(percent, 1992–2006)

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*U.S. nonfinancial business short-term assets consist of foreign deposits, checkable deposits, time and savings deposits, money market funds, repurchase agreements, and commercial paper.
Sources: Investment Company Institute and Federal Reserve Board