Death of mutual funds is much exaggerated

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The death of the mutual fund appears to have been much exaggerated. Money is flooding into mutual funds and industry observers predict 2006 will be a banner year.

Long-term mutual funds attracted net new money of $116.46bn in the first quarter, according to the Investment Company Institute (ICI), the trade body – an all-time record, comfortably beating anything the industry could achieve during its boom years of the late 1990s bull market.

The fact that mutual funds – which arrived in the US in 1924 – are still the most popular investment vehicle and are even gaining in popularity across the nation is something of a surprise. When the market turned in 2000, attention focused on hedge funds, which can exploit their relatively light regulation to make nimble moves that mutual funds are barred from making.

And in the last few years retail investors have focused on exchange-traded funds (ETFs), baskets of securities that trade on an exchange like stocks. Many affluent investors are also now opting for separate managed accounts (SMAs), which can offer greater tax efficiency.

But in spite of all the publicity, there is about $1.300bn in hedge funds, according to Hedge Fund Research, ETFs have only about $340bn under management, and SMAs remain a relatively exclusive taste. On the other hand, mutual funds’ assets last year overtook those of banks as the main repository for the nation’s savings, totalling $9,486bn.

The primary reason, according to industry experts, is that they are easy to use. Unlike hedge funds, which use complicated trading techniques such as short-selling and convertible arbitrage and have high investment minimums and long lock-up periods, mutual funds are straightforward and accessible. Even sophisticated investors appreciate the simplicity of investing in a mutual fund, according to David Haywood, director of alternative investment research at Financial Research (FRC), the Boston-based data company.

“Mutual funds are a tangible product,” says Mr Haywood. “They are familiar. Investors understand how they work, whereas they might not understand how hedge funds or private equity or ETFs work.”

The practicalities of investing in a mutual fund are also more clear-cut. “It is so easy to invest in a mutual fund. It is simple to put money in and it is simple to take money out,” he says. “For investors to be able to track their mutual fund’s performance in the news­paper every day – that is a big thing.”

Their ease of use has also made mutual funds the best-suited vehicles for retirement accounts, says Mr Haywood. “Mutual funds are a very competitive product for the defined contribution market,” he says. “They are firmly established and they are going to see continued success because they are basically an annuity with cash coming out of people’s pay cheques every two weeks.”

Indeed, the growth of mutual fund ownership has been largely fuelled by the expansion of 401k plans. Between 1999 and 2005 the number of households owning equities through employer-sponsored plans grew by 5.2m to 37.6m. And last year mutual funds accounted for $3,400bn, or 24 per cent, of the US retirement market, according to the ICI.

In addition to 401k plans, mutual fund providers have come up with new and creative ways to capture more of the retirement savings market. Target asset-allocation funds, the all-in-one investment geared toward a specific retirement date, have become increasingly popular.

A second reason investors opt for mutual funds is cost. Last year, the average asset-weighted expense ratio of all mutual funds was 0.91 per cent, according to Morningstar. The average expense ratio of a US domestic stock fund was 0.93 per cent, while international funds carried an expense ratio of 1.10 per cent. Compare that with hedge funds, which typically charge a 2 and 20 fee – 2 per cent of a fund’s assets and 20 per cent of its profit – and it is clear why many investors still go for mutual funds. True, ETFs have an average expense ratio of 0.4 per cent but the commissions paid to brokers tend to drive up the costs.

“Investors are attracted to mutual funds as a low-cost investment option,” says Brian Reid, chief economist at the ICI. “Funds are increasingly competing with each other and other investment products to provide performance and service at a lower cost.”

While some actively managed mutual funds do have big fees, the most popular ones have a relatively low total expense ratio – defined as the percentage of the assets spent to run a mutual fund.

Consumers seem to be aware of costs. According to the ICI, stock funds with below average expense ratios hold nearly 90 per cent of the total assets invested in mutual funds. And of the $136bn that flooded into stock funds last year, 30 per cent went to funds with an expense ratio of less than 50 basis points.

Aggressive marketing by several large mutual fund groups – led by Vanguard – has also rammed home this point to investors. Past returns may not be repeat­able in the future but low costs can be.

Mutual funds’ resurgent popularity in the first quarter of this year could also be attributed to improving financial markets – both at home and abroad. “The bear market is rolling off and there are some exciting macro-economic trends – such as energy and China – that are attracting investors,” says Russ Kinnel, director of fund research at Morningstar, the data company. “Foreign performance, in particular, is a big draw.”

Globally focused funds have seen tremendous inflows as international markets have outperformed domestic ones in recent years. In 2005, for example, total flows to international funds were a record $160bn but flows to international funds have already totalled $73bn in the first quarter of this year.

Emerging markets funds have especially benefited from this trend. Net flows in 2006 amounted to $7.2bn, and already year-to-date flows stand at $11.3bn. The next few weeks, after the huge blow emerging markets sustained in May and June, will show whether investors really want to diversify globally or whether they were merely chasing past performance.

Mr Kinnel says investors tend to feel more confident with mutual funds – as opposed to individual equities – for their international asset allocation. “People might feel they are competent to pick a domestic stock but they might not feel comfortable choosing say Dutch or Russian stocks,” he says.

There are limits to mutual funds’ success, however. While pricing pressures remain and many providers are cutting fees, they must do more to stay competitive, according to Mr Kinnel. “There are still funds that charge too much for their paltry returns,” he says. “If it keeps up they will feel a backlash in a few years.”

Mr Haywood, of FRC, adds that the industry – which has seen many trendy, sector-oriented product launches over the years – must adapt in order to provide a complement to other investment vehicles. The “style box” – a nine-square grid that classifies funds according to whether they use a “growth”, “value,” or “blend” style of investing is beginning to appear limiting, as investors and advisors fill their minds with more complicated notions from modern port­folio theory.

In the hedge fund world people talk about “beta” – correlation with the market – and “alpha” – returns that do not depend on the overall market. That may soon begin to infect the mutual fund worlds, particularly if the market does not mount a strong comeback from its latest downturn.

Already Morningstar, which introduced the style box in 1992, has added a new tool to give investors a more complete picture of a mutual fund’s holdings. The so-called “ownership zone” is derived by plotting each stock in the fund’s portfolio within the style box: the area in which most of the holdings fall is shaded to provide an representation of the area of the market in which the fund invests.

“Style boxes are going to break down, and from a product development standpoint we will see more all-cap type products,” says Mr Haywood. “Investors are going to look to hire managers who will deliver alpha, while beta will be obtained from passive products. Mutual funds will play the market between hedge funds and more exotic products and passive products but there will be some overlap.”

This is not to say that mutual funds will fall by the wayside. “Mutual funds are a great invention,” he says. “There are very few flaws.”

More on mutual funds: Lifecycle funds: taking a balanced approach to saving

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