Mutual funds used to be divided into two categories: ones that accepted institutional money and ones the little guys could invest in. But that's changing. Funds once available only to insurance companies, pension funds, and other institutional money managers are opening their doors to retail customers through discount-brokerage firms. "The rate of investment growth by individuals is hard to ignore," says James Schmid, a partner at Miller Anderson Sherrard (MAS), an institutional fund group owned by Morgan Stanley.
While a small group of institutional funds has always allowed individual investors, the number is growing. Of the estimated 700 institutional choices, more than 100 now welcome retail investors. That's up from only a handful two years ago, according to Morningstar, the Chicago-based mutual-fund research company. Just in the past few months, Rainier, Von Tontobel, and Fremont funds have all joined the retail ranks.
In the past, institutional funds locked out retail clients by keeping minimum purchase requirements a $1 million or more. Now, because of new selling agreements with discount brokerages, initial purchase amounts have dropped, sometimes to as low as $1,000.
LOW OVERHEAD. Individual investors, who have grown more sophisticated over the past five years, have been attracted to the institutional funds' higher returns. With the exception of small-company funds, institutional equity funds post better results than their retail equivalents because they have lower expenses. "It's not that institutional money managers do a better job investing," explains Jeff Kelley, senior editor of Morningstar Investor, a mutual-fund newsletter. "It's just that the institutional funds are cheaper, and that's money that goes into the investors' pockets instead of back to the fund company."
From 1991 through June, 1996, the typical institutional and retail U.S. diversified equity fund would have performed similarly, not including expenses. But because of the institutional funds' lower fees, they posted an extra $816, or 8%, on a $10,000 initial investment, according to Morningstar.
The expense ratio of the average U.S. equity fund is 1.2% of assets, compared with 0.93% for the average institutional fund. "As it compounds each year, the 27-basis-point advantage goes straight to the bottom line," says Kelley. Retail funds are more expensive because they have higher administrative costs and marketing fees and must process more buy-and-sell transactions from customers.
Of the 100 institutional funds open to retail investors, many more equity funds than bond funds are available. That's because bond-fund performance is more sensitive to the higher costs of servicing and marketing to large numbers of retail customers. And equity funds, especially small-cap and midcap growth funds, appeal more to individuals.
Surprisingly, the costs for an institutional-equity fund often don't go up when it opens its doors. Discount brokerages, such as Charles Schwab, Jack White, and Waterhouse Securities, do all the necessary back-office work and charge either the institutional-fund account an annualized fee of 25 to 35 basis points or the retail client a transaction fee for the purchase. "We didn't want to build the infrastructure to support the retail client, but the discount brokerages make it easy and inexpensive to service them," says MAS partner Schmid.
Institutional funds also don't increase advertising and marketing efforts, and thus expenses, when the fund base widens. "While the funds are available to individuals, we are not courting them," says a spokesperson for PIMCO Advisors, a mutual-fund family with an extensive institutional portfolio.
Lower costs and higher returns aren't the only advantages. Another benefit is focused investment style. Institutional managers usually stay fully invested and have well-defined strategies, avoiding niches such as socially conscious investing or environmentally friendly stocks. They focus on how their funds compare with a specific investment style rather than against a broad universe, such as the Standard & Poor's 500-stock index or the Russell 2000. Take, for example, the high-performing Quantitative Group Numeric Fund, which invests only in small-company stocks. It returned 19.46% for the three years ending on Aug. 31.
A number of retail funds, on the other hand, suffer from what is known as "style drift." Managers of these funds wander from the mission stated in the annual report or prospectus. Whether the change is in risk level or investing style--say, from value to growth stocks--it's difficult for an investor to keep tabs. Most important, that "drift" wreaks havoc on the balance of a portfolio, especially if the investor chose the fund for its strategy.
Finding institutional funds and their performance records can be tricky. One option is to call a discount brokerage. Unfortunately, customer representatives don't always know that institutional funds are open, so you may have to push them to investigate. You can also call 800 435-4000 or tap into http://www.Schwab.com on the World Wide Web to request Schwab's free guide to mutual-fund performance. Most institutional funds open to individuals are listed in Schwab's marketplace of 1,100 funds, along with their returns. You don't have to be a Schwab customer to receive the information.
You can also proceed the old-fashioned way. Fee-only financial advisors have had access to these funds for years. You'd have to pay the typical fee of 1% of assets, but any front- or back-end loads would be waived. This new universe of funds won't supplant the extensively advertised retail funds. But they do give you an entree into the same league as the big guys.