Municipal mutual fund investors have consistently demonstrated that they want income, not total return, according to Tom Kenny, senior vice president and director of the municipal bond department at Franklin Advisers Inc.
Over the past 10 years, he pointed out, Smith Barney's Managed Municipals Fund has only grown from $1.7 billion to $2.4 billion, despite being run aggressively for total return by Joe Deane.
Meanwhile Franklin's municipal funds have grown from $13 billion in total assets to $42 billion, Kenny said.
"If investors really want total return in the fixed-income markets, why is it we are double the size of our closest competitor?" he asked.
Franklin's funds are managed to achieve a high but stable level of income, minimum variation in net asset value per share, and minimal capital gains payout, Kenny said.
Reliable, predictable performance, he believes, is what made Franklin the biggest municipal mutual fund group.
The philosophy has been unchanged since Andy Johnson launched the first Franklin tax-free fund in 1979, Kenny said.
Based on Research
Johnson came from a background of working with retail investors, he added.
"He did a lot of research before starting the tax-free group and knew investors buying tax-free products want tax-free income," Kenny continued. "They don't want capital gains; they don't want to time the market.
"Today we figure there's no reason to change. It's been very successful and it works. The numbers prove over time it's a great philosophy.
"What lends credence to that is if you ask most brokers, 'Why buy our funds?'
"They say, 'You know what income you are going to get over time and you are not going to get killed.' "
In fact, investing for income does not have to mean giving up total return, Kenny said.
Using Lipper Analytical Services Inc. data, he looked at the performance of Franklin's Federal Tax-Free and High-Yield Tax-Free funds over the past three years, which include two bull markets, when total- return funds should do well, and a bear market, when income funds should perform better.
In 1993, the high-yield fund beat the average total return by almost 200 basis points and ranked sixth out of 28. It yielded 80 basis points higher, ranking fourth out of 27.
The national fund was 110 basis points under on total return and ranked 100th out of 130 but did 100 basis points better on yield to rank first out of 129 funds.
In 1994, the picture was transformed. Franklin's high-yield portfolio beat the average by 240 basis points on total return, ranking sixth out of 36, and was 50 basis points higher on yield, ranking eighth out of 35.
The national fund beat the average by 280 basis points on total return, ranking 15th out of 184, and 130 basis points on yield, again ranking first.
The 1995 performance to Nov. 30 was similar to 1993. The high-yield fund beat the average by 40 basis points on total return to rank 30th out of 43 and 60 basis points on income to rank fourth.
The national fund underperformed by 160 basis points on total return to place 200th out of 236 but did 120 basis points better on income to rank fourth.
Overall the high-yield portfolio did 452 basis points better than average on total return and 193 basis points better on income. The federal fund beat the average by 59 basis points on total return and 353 basis points on income.
'Income Drives Total Return'
"Two out of those three years were in a very strong market. I thought we would look terrible from a total-return standpoint," Kenny remarked.
"But what we actually found was we are either at the averages or actually above the averages from a total-return standpoint.
"It really supports how we do this - over time total return is driven by income.
"How could anyone argue that these shareholders over the last three years have not done well by the Franklin funds?"
Furthermore, the performance has been achieved without the risk of total-return investing, he said.
There one bad year can undo the effect of a successful run - and all from making a wrong call on the direction of interest rates.
"If you are a total-return player and you are right in one year in terms of your direction on rates and where rates are going to be and your couponing approach, you might hit a home run.
"Next year you might be down 14% or 15% - as many funds were last year.
"All it takes is one bad year and you have ruined investor confidence in your funds."
Kenny also pointed to the Lehman Brothers 20-year municipal index. Between 1989 and 1994, 99.36% of the total return was from income, 0.64% from capital appreciation - reflecting the cycles in the market.
However Kenny emphasized: "Total return is important. Total return over time is the gauge.
"But it's how you achieve total return that's important. You can still achieve total return by investing for income."
Background
The reason most firms focus on total return rather than income is their background, Kenny said.
"If you look at the genesis of most firms that are in munis, their expertise is in equities," he said. "In equity markets you live and die for total return.
"What you have is 90% to 95% of the portfolio managers in our business are getting compensated on a total-return basis."
Franklin started as fixed-income investors, Kenny said, and the system for compensating portfolio managers includes performance gauged by total return ("important" but a "small component") and by income ("very important").
Payments are also influenced by how well portfolio managers work with research staff and their attention to sales and marketing, including the managers' roadshows and their availability to brokers and the press.
Credibility With Brokers
The consistency of a yield-based approach also makes it easier to sell Franklin funds through brokers, continued Kenny, who said he spends "a lot of time marketing."
There is much less risk of a bad streak that will blow a fund's credibility, he said, and the same approach can be explained year in and year out.
"The broker-dealer community you live and die by," Kenny said. And the first task is "to get them to buy into your philosophy."
Franklin's distribution is through wirehouses and financial planners, the latter being increasingly important, Kenny said.
The firm sees itself as having low loads - 4#1/4% upfront compared to the 4#1/2% or 4#3/4% typically charged - and low expenses - around 50 basis points against the prevailing 75, 80, or 90 basis points.
For the class II shares, the investor puts up 1% and Franklin puts up 1% to give the broker 2%.
