Mutual Fund Industry Faces a Run for Its Money

Seventy-five years and more than $5 trillion after the modern mutual fund was born, the fund industry is finally showing signs of age.

For the first time in a decade, Americans’ net new investment in stock funds declined significantly last year from the previous year, according to industry data released Thursday.

While mutual funds over the last decade have arguably been the greatest democratizing force in the history of Wall Street--allowing even investors with modest sums to ride the spectacular 1990s stock bull market--the industry now faces increasing competition for its mountain of dollars.

On one front, more investors are opting to manage their own money rather than pay mutual funds to do it. The current mania for Internet-related stocks is one manifestation of that trend, experts say.

On another front, some investors’ mutual fund accounts have grown so large that they are ripe targets for the fund industry’s key competition, including full-service brokers and private money managers.

To be sure, mutual funds remain the hands-down favorite investment vehicle for most middle-class Americans, especially in their 401(k) retirement plans.

Not only do the funds allow investors to put small amounts of their savings into securities markets--relatively safely--but they also promise higher returns than passbook savings accounts or bank certificates of deposit ever could.

Still, “we’ve gone from a high-growth industry to a rapidly maturing business,” said Jeffrey Shames, chief executive of Boston-based MFS Investment Management, whose company created the first modern fund, Massachusetts Investment Trust, in 1924.

“All of the easy market share gains have already been made,” he said. “Most people who have ever thought of switching out of traditional bank savings or cash have already done that and own mutual funds.”

Now, fund companies aren’t expanding the pie so much as they’re guarding their pieces.

Indeed, more than a third of the nation’s 613 fund companies experienced net redemptions in 1998--meaning investors pulled more money out than they put in, according to figures compiled by Financial Research Corp., a financial services consulting firm in Boston.

The industry’s fear is that, in the face of a true sustained bear market in stocks--something that hasn’t occurred in a quarter of a century--the fund business may go from slow growth to no growth.

The industry’s experience last year with new investments and redemptions by its 66 million individual investors point up some of the challenges the business faces.

Gross purchases of stock funds totaled a record $702 billion, up 21% from 1997, according to the Investment Company Institute, the funds’ chief trade group.

But investor redemptions from stock funds rocketed 48% to $534 billion last year, as many more investors cashed out--many of them amid the market turmoil late last summer.

Adjusting purchases for redemptions and exchanges within the same fund families, the net amount of new cash invested in stock funds tumbled to $158.8 billion, down 30% from the record $227 billion in 1997 and $222 billion in 1996.

“I think too much is made about cash flows,” argued John J. Brennan, chief executive of Vanguard Group, the second-largest mutual fund firm. “In real dollar terms, the amount of cash flows that have come into the industry in the aggregate over the past five years has been unbelievable.”

Even in 1998, while net cash inflows to stock funds fell, investors hardly abandoned the industry. They poured $235 billion into short-term money market funds and $74 billion into bond funds.

But stock funds remain the industry’s bread and butter, holding 54% of the total $5.4 trillion now invested in mutual funds and charging far higher management fees than money funds or bond funds--fees coming directly out of investors’ fund assets each year.

And for the fifth consecutive year, more than three-quarters of all so-called actively managed mutual funds in 1998 failed to beat the benchmark Standard & Poor’s 500 stock index.

That is causing more investors to wonder why they should bother with funds.

These are people like Muriel Hykes, 43, a part-time nutritional consultant in Cogan Station, Pa., who chose two years ago to bypass funds and to manage her own money.

“When I started looking at the performance of these funds, I asked myself, ‘Why should I pay somebody else to do something I can do myself?’ ” she said.

So she set up three online brokerage accounts to trade individual stocks, including a $12,000 individual retirement account.

The soaring prices of Internet stocks in recent months, fueled largely by individuals, are making it appear far more lucrative for average investors to play directly in the market than hand their money to a fund, experts say.

Competitive threats like that are more worrisome for the fund industry in part because the nation is about to see the greatest wealth transfer in history, as baby boomers are expected to inherit from their parents an estimated $13 trillion over the next 15 years, argues Lou Harvey, president of Dalbar, a Boston-based research firm that tracks the financial services industry.

“You can bet that money is not going back into savings accounts earning 2%,” he said.

But how much of that money mutual funds can retain will largely depend on how they react to the changing investing landscape. That landscape includes several new challengers.

For starters, as mutual funds are making middle-class Americans wealthier, full-service brokerages are attempting to pick them off, luring high-net-worth investors (those with about $500,000 to invest) into so-called wrap accounts, stock portfolios that are custom-designed to meet individual investors’ needs, analysts say.

“The attraction is that the managers of these separate accounts, or customized mutual funds if you will, will make decisions based on your specific situation,” said Andrew Guilette, analyst with consultant Cerulli Associates in Boston.

Of course, these wrap accounts are expensive. And, as Harvey argues, “there’s a lot of bucks under $500,000” for the funds.

At the same time, online discount brokers, with their low commissions and Internet technology, are attempting to convert more fund investors into stock traders.

If this is having any effect, it’s happening at the margins, analysts say. Many note, for instance, that the vast majority of investors still desire professional guidance. Argued Vanguard’s Brennan: “I don’t think Internet trading has much of an impact [on us] at all. It’s a fad more than anything.”

But at the very least, “the investor now has at his or her fingertips an unprecedented amount of knowledge,” Guilette said. “For most, this will overwhelm them. But it does raise the overall level of expectations investors have of their mutual fund managers.”

There are signs that the fund industry is reacting. Analysts predict, for instance, that fund companies will soon offer high-net-worth investors more premium services--and advice--to compete with full-service brokerages bearing wrap accounts.

For example, one reason that a number of fund companies, including Fidelity Investments and T. Rowe Price, have recently applied for federal thrift status is that they eventually want to offer to their wealthy clients a fuller array of trust and estate planning services, said David Haywood, an analyst with Financial Research.

At the same time, funds themselves will probably continue a recent trend of making bigger bets on a smaller number of stocks--to attract and retain investors who may be swayed by the potentially eye-popping returns they could earn by investing on their own, such as in Internet stocks.

Fund consultants point to the rise in new “sector” funds, portfolios that only invest in a specific industry, such as technology.

According to a preliminary count by Lipper Analytical Services, 98 new sector funds were launched in 1998, a 72% rise from 1997.

These funds cater to people like Ricky Scatterday, a 22-year-old senior at Cal State Fullerton who a year and a half ago moved money out of Fidelity Blue Chip Growth, a diversified stock fund, and began trading sector funds managed by Invesco and Rydex.

“It’s the challenge of trying to beat the market on my own, I guess,” said Scatterday, who has about $20,000 invested in mutual funds.

The fund industry argues that the challenges it faces are perennial ones, not new ones. Still, the sheer size of the industry today means growth from this point will be slower. As a percentage of total assets under management, net new fund investments grew only 7% last year, down from a 30% annual rate in the early-90s.

That slowdown is already leading to record levels of mergers within the industry, as fund companies realize they may have a better chance of gaining assets--and thus greater fee income--by merging rather than relying on internal growth.

Even now, the 10 largest fund firms control 52% of all market share, up from 42% a decade ago.

In the event of a true bear market in stocks, says MFS’ Shames: “We’re going to see dramatic consolidation in this industry.”

Vanguard’s Brennan, who also serves as ICI chairman, counters that “if you’ve got between 5-10%, that’s a very good real growth rate for any mature industry.”