Industry’s Recent Chills No Sign of Grave Illness

Is the mutual fund boom about to go bust?

That question has been asked many times over the past decade, a period of dizzying growth in the number of mutual funds, shareholders and assets.

Surging stock and bond markets during that period have made mutual funds an increasingly attractive place to be. Investors today have $2.1 trillion parked in roughly 5,400 funds, up from $1 trillion and 2,900 funds at the end of 1989.

But now the stock and bond markets are hurting, and net sales of mutual funds have started to turn lower. There are even signs that employment in the business is topping out.

Taken together, do all of these factors suggest that a contraction or shakeout in the fund industry might finally be on the horizon?

No way.

Despite slower times in a more hostile investment climate, the fund industry and most individual fund companies aren’t hurting. Consequently, there’s little likelihood of serious consolidation anytime soon.

“Fund companies are still very profitable and are coming off a strong run,” says Kurt Cerulli of Cerulli Associates, a Boston financial consulting firm. “The industry hasn’t gone through enough trauma for a consolidation to get serious.”

Anyone who predicts the mutual fund industry might start to deflate should be asking themselves where investors would head. Might there be a mass exodus toward individual stocks or bonds? Not likely, considering that funds offer diversification, professional management and other benefits for competitive if not lower costs.

How about a massive return to the safety of bank accounts? Short of a huge spike in interest rates, this isn’t probable either.

“Why should any person seeking growth of their net worth stay with bank deposits?” asks George M. Salem, banking analyst for Prudential Securities in New York. In terms of long-term growth potential and investment choice, the bank products simply can’t compete, he says.

In fact, banks themselves have been racing to enter the mutual fund business as a way to offset the outflow of deposits. Many insurance companies are also big players, and they’re enjoying strong sales from variable annuities--a close kin to mutual funds.

Certainly, a severe and enduring bear market would drain a lot of money out of stock funds, but it’s likely that much of this cash would merely shift into bond, foreign, money market or sector funds (such as gold portfolios), where it would await the start of the next bull market.

Because stock funds are typically the most lucrative to manage and money market portfolios the least so, profit margins would come under pressure, but the industry itself would survive.

In short, there’s little chance anytime soon of a massive downsizing as happened in the steel and auto industries in decades past, says John Keefe of Keefe Worldwide Information Services, a New York financial consulting firm. The economics of the business are still too positive for that to take place.

Overall industry assets will continue to enjoy healthy growth punctuated by periods of investment surges, predicts Bill Klipp, chief operating officer of brokerage Charles Schwab’s mutual fund group in San Francisco.

But the industry is facing another type of consolidation. Fewer fund companies have been commanding a larger market share for the past decade, Keefe says, and this will continue to fuel merger activity.

Of roughly 350 fund families today, the 10 largest control 48% of the market, according to Dalbar’s FundRate, a Boston research service. Because these giants typically can boast of top management skill, first-rate shareholder service operations, innovative new products and the most complete lineup of funds, it’s likely they will continue to carve a larger slice of the pie.

This consolidation trend has been overshadowed by the mushrooming number of funds in recent years. New competitors, attracted by the high profitability of the business, haven’t faced many entry barriers. “You don’t need a lot of capital, plant or equipment to start a mutual fund,” says Klipp. But with slowing sales, tighter profit margins and increased competition, that is likely to change. “There will be a substantial slowdown in the creation of new fund companies,” he predicts.

Many of the new entrants in recent years have been the banks. But here too there’s reason to expect a drop-off in new activity. “Many banks that started to sell mutual funds within the last few years with high hopes have been sorely disappointed,” says Cerulli.

When a prolonged period of heavy shareholder redemptions materializes, some of the smaller, weaker bank groups will be among the first to sell out, he predicts.

Smaller groups in general might not be able to subsidize unprofitable funds during a lengthy slump. Stock funds need at least $60 million in assets to break even, Cerulli estimates. For bond and money market portfolios, which charge smaller management fees, the break-even points are closer to $150 million and $200 million, respectively, he says.

But a prolonged period of shareholder withdrawals isn’t yet on the horizon, which means there aren’t a lot of motivated sellers among fund companies. This explains why merger and acquisition activity remains modest, despite what observers say are high prices for anyone wanting to unload a fund company at this time.

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Thomson Advisory Group of Stamford, Conn., last week signed a definitive agreement to merge with the Pimco fund group and four other money-management subsidiaries of Pacific Mutual Life Insurance Co., headquartered in Newport Beach.

The transaction, first announced in March, would create a new firm called Pimco Advisors, also to be based in Newport Beach, with $70 billion in assets.

The new entity would count 22 mutual funds with roughly $14 billion in assets, placing Pimco Advisors among the 30 or so largest fund groups. The combination would open Pimco funds for sale through Thomson’s brokerage network.

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Even with a pickup in economic activity around the globe, U.S. inflation should remain in the 2% to 4% range over the next several years, predicts William H. Gross, a Pimco bond fund manager and managing director of the company.

While rising commodity prices are a concern, “wages are the primary source of inflation, and they remain in a downward trend worldwide,” says Gross, who runs two bond funds given top five-star rankings by Morningstar Inc. of Chicago.

He predicts fairly stable interest rates ahead, with 30-year Treasury bonds yielding between 6.5% and 8.25%.

How Many Funds?

The advent of multiple-class pricing in recent years has made it harder to compute the total number of mutual funds. It also explains why you might see fund tallies from different sources vary by several hundred or more.

Multiple-class pricing has become popular among investors who use brokers and financial planners because it offers choices for paying the commission.

A fund’s Class A shares are typically sold with a front-end sales charge or load attached. Class B shares are usually sold with an annual “12b-1,” or marketing, fee and a declining back-end charge. Class C shares might feature a yearly 12b-1 fee only, and so on.

Each of these fee structures will produce a different total return, because 12b-1 fees are subtracted from the performance numbers, while front- or back-end sales charges generally are not. This is why you see separate price quotations for A, B and C shares in newspaper fund tables, even though they’re all based on the same fund--that is, the same portfolio of stocks or bonds.

Lipper Analytical Services, a premier fund-monitoring service in Summit, N.J., today reports performance on more than 6,300 mutual funds, but a little more than 900 of these are multiple classes of shares. That leaves a more accurate tally of about 5,400 true funds--still a large tally, no matter how you slice it.