Mutual Funds: the Opportunity for Tomorrow’s Entrepreneurs

Want to be an entrepreneur? Want to turn clever ideas into truly big bucks? Sure, you can go the software and/or Internet route, but isn’t “geek chic” just a teensy bit of a cliche these days? Biotech is nifty too, but who wants to deal with all those messy microorganisms and even messier FDA approvals?

No, the biggest multitrillion-dollar opportunity in the world today isn’t made of silicon, software or DNA. It’s made of money. Lots of it. The dynamic, innovative and competitive entrepreneurial marketplace of tomorrow is going to be mutual funds. Look at the numbers: In 1985, more than $495 billion was invested in mutual funds. In 1990, that number had doubled to more than $1.06 trillion. By the end of last year, mutual fund holdings had nearly tripled to more than $2.8 trillion. Billions more are gushing in every week. This is emphatically a market big enough and deep enough to support entrepreneurship.

More important, look at the underlying dynamics of the mutual funds market. You might feel the first breezes of what economist Joseph Schumpeter once described as the “gales of creative destruction.”

The biggest and most successful funds--notably, Fidelity’s Magellan--have grown so immense that it becomes almost statistically impossible for them to significantly outperform the market. They are truly becoming victims of their own success. That doesn’t mean these giants will wither and die; it means more and more investors may feel they have to turn elsewhere for higher returns. To be sure, the Fidelitys and Vanguards of the world offer an ever growing menu of mutual funds for their investors to consider. But why should the future of this multitrillion-dollar market belong to the companies that created it?

This is an industry where the barriers of entry seem to shrink each and every year. Regulatory compliance hardly poses an obstacle. Certainly the computational and telecommunications costs of managing complicated portfolios are declining. You can do a sophisticated mathematical analysis of historical stock performance today roughly 10 times faster and at about one-thousandth of what it cost in 1986. Next year, it will be cheaper still--and there will be even more investment data to play with.

Outsourcing a back office and renting a telemarketer is just a couple of phone calls away. The Internet has yet to be effectively tapped as a medium for both promotion and distribution. In short, the infrastructure investment for setting up a mutual fund is definitely cheaper than for launching a biotech firm and certainly comparable to trying to start up the next Netscape or Yahoo.

So what’s missing? Ideally, your own Peter Lynch or Warren Buffet. Failing that, what you need, of course, is a terrific idea--the sort of compelling investment story you can build a mutual fund, or a family of mutual funds, around. These days, the mutual fund stories revolve around “value investing” or “momentum” stocks. Of course, there have been tremendous successes building mutual funds around overseas investments on both a regional and national basis. Some themes, such as “socially conscious” funds, haven’t done so well. Other themes, such as “small-cap high tech” stocks, are hot.

But we’re just witnessing the first and most obvious generation of mutual fund innovations. In a multitrillion-dollar marketplace all kinds of interesting and provocative investment themes will emerge. We will see as rich and varied a selection of mutual funds as we do of companies. In a data-rich, information-intensive environment, entrepreneurs will not only have all sorts of investment ideas to test in the mutual fund marketplace, they will be able to generate the historical data to support them.

For example, consider “The Consultants Fund.” Here is a fund operating off the perfectly rational premise that consulting firms such as McKinsey & Co., Bain, Booz Allen and Monitor have an impact on the companies that they advise. Historical analyses can determine just how much value these firms added to their clients’ share prices. This requires a research boutique to track which consultants are working with what publicly traded companies. Investors could then invest in a basket of the consultees.

Then again, we can offer a hedge: Investors who believe consultants are “value-subtractive” could buy into “The Consultants Short Fund.” All we need is the appropriate data to see what kinds of correlations exist between consultants and shareholder value.

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Or what about funds based on more ethnic appeals? Why not a portfolio of publicly traded companies that have outperformed the S&P; 500 that are run by immigrant Chinese or Indians? Would mutual funds employing the ethnicity of top managers as investment screens make it easier to raise capital from their communities?

Perhaps a comprehensive statistical survey might reveal that companies run by left-handed PhDs in the hard sciences tend to outperform the Dow. Maybe companies whose median wage is more than 20% lower than a median wage index are companies that consistently under-perform. Who knows? The practical reality, though, is that investors will inevitably see more and more data-driven-designed mutual funds in the marketplace. Each should have an immaculately documented pedigree of successful past performance. Why not bet the future will look as good as that past?

The academic theorists argue that the “efficient market hypothesis” guarantees that most of these mutual funds will be short-lived; the market will inevitably take their “stories” into account. But so what? You can live quite handsomely off a 1% management fee on a $100-million mutual fund for two or three years. If you acquire a reputation for clever mutual fund innovation, your second or third fund start-ups might attract $1 billion or $2 billion. That’s a comfortable living too.

“I don’t think that this is farfetched, particularly in today’s environment,” observes George Gould, an undersecretary of the Treasury in the Reagan administration. “I think there’s room for a hell of a lot of stuff. . . . I mean, why shouldn’t there be ethnic funds?”

“I think it’s a totally rational way to approach starting a fund as a business proposition,” acknowledges Mark M. Carhart, as assistant professor of finance at the USC School of Business who researches the survivability of mutual funds. “It’s low-cost, it has a positive net present value, it makes sense--but please don’t count on me investing in those funds.”

Not for the moment, perhaps, but it’s only a matter of time before the level and intensity of entrepreneurship in mutual funds makes the software and biotech biz seem stodgy by comparison.