Testing the Appetite for Risk
Three months into the new millennium, a fresh image of the American investor is coming into focus. And mutual fund companies are finally, and perhaps begrudgingly, getting the picture.
We want to take bigger risks and we expect bigger rewards. More than 75 cents of every new dollar we’ve plunked into mutual funds this year has gone into a technology-sector fund or other highflying growth fund.
With the market’s latest sell-off, that may well reverse in the short term. But the trend has shown just how willing many investors have become to make out-sized bets in search of greater returns.
We’re impatient. Even as record sums pour into aggressive funds, many of us are redeeming record sums from other stock funds that haven’t lived up to our hopes.
Diversification no longer matters much to many of us. Demand for traditional diversified “growth and income” funds and other diversified portfolios has faded. Instead, concentrated portfolios that make big bets on just a handful of stocks are booming in popularity.
We hate paying taxes, and we want to be able to structure portfolios that minimize taxes. Hence, interest is rising in “managed accounts” and in exchange-traded “basket” securities, both of which offer fewer capital-gains tax headaches than mutual funds.
In short, many of us have become the antithesis of the conservative, buy-and-hold investor that mutual companies routinely pictured--and courted--throughout the last century. “The retail investor has a much shorter time horizon than ever before,” says Philip Edwards, managing director for Standard & Poor’s Fund Services in New York. The view is, “I want to make money today,” he says.
Thus, fund companies that historically avoided tech-sector funds (such as Neuberger Berman and Baron Capital) now are coming out with them. More fund giants are launching concentrated growth funds, a la the wildly successful Janus funds formula. And many fund firms are changing their view of what constitutes “value” in an equity portfolio.
To be sure, many market pros say the surge in risk taking by fund investors merely reflects the general mania for hot stocks, particularly tech issues, that swept Wall Street during the last year. Now, with many of those stocks in a free fall, it’s easy to suggest that small investors will quickly reject risk taking--and the bevy of new, higher-risk investment options.
But some fund industry veterans say the genie is out of the bottle. “Fundamentally, we’re seeing an important and I would argue permanent shift” in what investors want in terms of choices to structure their portfolios, and in how fund firms respond to those desires, says James Atkinson, head of the Pasadena-based U.S. operations of fund company Guinness Flight.
Simply put, many fund firms are recognizing that many people don’t invest along the lines of the styles by which the industry has long defined itself (i.e., “mid-cap growth,” “aggressive growth,” etc.).
Instead, many investors at any point want to buy what’s new and exciting and promising--the way they buy any other product.
Regardless of how the current tech mania ends, many analysts see the slicing and dicing of fund sector offerings, the growth of “enhanced” portfolios and the rise of competing basket securities as permanent changes demanded by investors who want more flexibility with their portfolios.
Giving the customer what he or she wants is hardly big news in most industries. But this is the mutual fund business. For years, the relationship between shareholder and fund has been less customer-merchant and more patient-doctor. Put your interests in our professionally trained hands, funds would argue, and we’ll take care of you.
It was a powerfully attractive message for most of the past century. But is it as relevant today?
Until recently, funds have been “extremely paternalistic,” says Atkinson. “Find me another industry--maybe the medical profession--that purposely doesn’t offer customers what they want?”
The rules are changing, however, as investors themselves are more informed and more empowered by what they can find, and do, online. Moreover, formidable new competitors for funds have arrived.
Among the new competitors are so-called basket securities, which include Standard & Poor’s depositary receipts, commonly referred to as “Spiders,” and World Equity Benchmark shares, or WEBs.
By investing in one of these exchange-traded securities, you gain exposure to all the stocks in a particular market index, much as you would through an index mutual fund--but with the added advantage of being able to trade them intraday, like a single stock.
Also, the securities give investors more ability to control when capital gains are taken. Mutual funds, by contrast, often realize and pay out large gains annually.
Dozens of new exchange-traded funds are set to launch this year.
In addition, managed accounts, individual portfolios specifically created by and managed by investment pros for high-net worth investors, are growing in stature. A new report by consulting firm Cerulli Associates in Boston estimates that managed or “wrap” account assets now stand at $512 billion, up more than 43% from a year ago.
Meanwhile, direct stock investing by individuals, on their own or through investment clubs, remains a booming trend.
Given all of these alternative investing modes, “fund companies are seeing they need to compete,” says Thomas Lydon, head of Global Trends Investment, an investment advisor in Newport Beach.
Despite record net new investment in stock funds in recent months--by one estimate, the funds pulled in nearly $150 billion of net new money in the first quarter--eight fund firms are bleeding assets for every five that are enjoying new money, according to the research firm Trimtabs.com.
To turn those cash flows around, fund companies increasingly are putting new or revised product offerings on the table. Among the most visible offerings:
* “Concentrated” funds. They were once considered too risky for the average investor. But the success of Janus Twenty, a wildly popular growth fund that makes big bets on a handful of names such as America Online and Cisco Systems, changed all that.
Today, concentrated funds are commonplace at most mainstream fund complexes. Even “core” diversified funds, such as Bill Miller’s Legg Mason Value, are becoming de facto concentrated funds.
For some investors, concentrated funds offer a way to achieve with a fund what an individual would do in creating his or her own stock portfolio: focus on a couple of dozen (at most) great ideas, instead of owning scores of marginal ones.
* More “alphabet” fund shares. A growing number of fund companies are selling multiple-share classes of their existing funds. The basic idea: Give the investor more choices in terms of how a fund is purchased (i.e., with a broker’s advice or without) and in terms of how fund fees are paid.
Los Angeles-based American Funds recently created “B” class shares for its broker-sold flagship funds, offering investors the ability to pay brokers later for their help, rather than upfront.
Meanwhile, no-load fund companies such as Dreyfus and Invesco are adding load-share classes for investors who want to invest with the help of a financial advisor.
* More thematically oriented funds. Until recently, most new fund products have fit nicely into one of Morningstar’s nine domestic “style boxes”--such as “large-cap growth” or “mid-cap blend.”
Today, a small but growing number of fund companies are thinking outside those boxes. Many now concede that individuals don’t really buy funds that way--even though, analysts say, it’s still useful to judge funds based on these categories, to get an apples-to-apples comparison of performance. (See tables on pages S14-17.)
“Fund companies are beginning to differentiate their products in a way that customers will understand,” says Ed Rosenbaum, head of research at New York-based fund tracker Lipper Inc. “Large-cap growth, small-cap value--those aren’t personal investment objectives.”
Contrast those generic terms with themes people can quickly grasp, and even get excited about. Among them: “New-economy” funds that invest in companies expected to flourish in the information-driven economy.
Another example: The Medical Fund, a portfolio managed by Kinetics Asset Management that focuses on companies working on cancer-related products.
* Technology offerings in many flavors. No fund sector has captured the public’s imagination like tech has during the last year. But what was once viewed as single sector now is viewed for what it has become--an industry of industries, some of which may be rising even as others decline.
Hence, niche funds are developing within the Internet sector. Amerindo Investment Advisers is opening a fund that targets business-to-business Internet plays.
* “Value” funds without income requirements. To accommodate the new breed of tax-averse investors, and to juice up their portfolios in a market that is increasingly emphasizing capital appreciation over dividend income, many old-fashioned “equity-income” or “growth and income” funds that required the fund manager to invest in dividend-paying or dividend-growing companies have relaxed, or are trying to relax, those requirements.
American Century Heritage, American Century Select, Scudder Growth & Income, Pilgrim Magnacap and Firstar Growth & Income are among such funds.
Of course, critics may well classify many of these new or revised fund offerings as fad products that will quickly disappear in a market downturn. But many fund companies see increasing product innovation as a permanent shift.
“This is a mature business, and in any mature business, you start segmenting the market finer and finer,” says Jeffrey Shames, chief executive of Boston-based MFS Investment Management.
“It’s like Tide,” says Shames, referring to the laundry detergent. When you go to the supermarket, you see “small boxes of Tide, regular-sized boxes, liquid Tide, Tide with bleach.”
Notes Geoff Bobroff, a mutual fund consultant in East Greenwich, R.I.: “We have yet to see all the variations that the mind can dream up.”
But should there be a limit to how much risk taking fund companies encourage via new products?
Rockville, Md.-based Rydex Mutual Funds is set to launch later this year a line of four “enhanced” funds. Each will be enhanced 200%: For instance, when the Nasdaq 100 index (representing the largest non-financial companies in the Nasdaq composite) jumps 3%, Rydex’s enhanced Nasdaq 100 fund would be expected to rise 6%.
Likewise, the fund would fall twice as hard in a downturn.
More significantly, these funds will be priced twice a day, not just once a day, as are most funds. Until now, Fidelity Investments’ sector funds have been the only ones that offered intraday pricing.
Expanding to more than twice-daily pricing “is a possibility if the market is showing a demand for it,” says Rydex spokeswoman Elissa Golan. But first, she says, “we want to see how the market will react.”
Many analysts say that as fund investors become more aggressive, intraday pricing will become more important to them.
Intraday pricing will certainly help Rydex compete against exchange-traded funds. Elsewhere in the industry, major fund companies are reportedly working to create exchange-traded versions of some of their actively managed funds.
Sheldon Jacobs, editor of the No-Load Fund Investor newsletter in Irvington-on-Hudson, N.Y., says “all of these trends are making funds a bit more like [individual] stocks. And there’s an argument that one could make that that’s wrong.”
Avi Nachmany, analyst at fund-research firm Strategic Insight in New York, agrees. Fund managers are “really torn apart by the reality of the marketplace today and the other reality--that you’re really the guardian of most people’s retirement money.”
“Should you reorient your product line to say, ‘I’m only going to buy new-economy stocks that don’t [show profits] or [boast] price/earnings ratios of 100 or more because that’s what works?” he wonders.
The long-term risk for the industry is that “consumers aren’t going to read the prospectuses of these new products,” says Lou Harvey, president of Dalbar, a Boston-based research firm that tracks the financial services industry.
“They’re going to see the words ‘mutual fund,’ they’re going to think all the good things they associate with mutual funds, and if it blows up in their faces, it will do damage not just to the investors, but to the rest of the fund industry,” he fears.
Still, industry analysts agree that whichever path the stock market takes, most individual investors aren’t likely to revert to wanting only the staid offerings of old.
“We’re now in a period of extraordinary awareness of investment results and extraordinary sense of personal investment empowerment that comes from instantaneous access to performance information,” Nachmany says. “Clearly, the velocity of [mutual fund] flows has increased tremendously. And it’s here to stay.”
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Are Your Managers Overpaid?
Mutual fund expenses for operations and management fees are reported as an “expense ratio, the percentage of fund assets taken annually by the fund company. Certain kinds of funds are more expensive to run than others, so investors should compare their funds’ expenses with the category averages, shown below.
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Equity funds
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Avg. expense Category ratio Latin America 2.8% Diversified Pacific/Asia 2.8 Pacific/Asia ex-Japan 2.3 Div. emerging mkts. 2.2 Precious metals 2.0 Japan 1.9 World 1.9 International hybrid 1.8 Natural resources 1.8 Europe 1.8 Technology 1.8 Foreign 1.7 Small growth 1.7 Health 1.7 Financial 1.7 Mid-cap growth 1.6 Convertibles 1.6 Real estate 1.6 Small value 1.5 Communications 1.5 Small blend 1.5 Large growth 1.5 Utilities 1.4 Mid-cap value 1.4 Mid-cap blend 1.4 Large value 1.4 Domestic hybrid 1.3 Large blend 1.2
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Bond funds
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Avg. expense Category ratio Emerging markets 1.7 Multi-sector 1.4 International 1.4 High-yield (junk) 1.3 Intermed-term govt 1.1 Muni long-term 1.1 Long-term invest grade 1.0 Short-term govt 1.0 Muni interm-term 1.0 Inter-term invest grade 1.0 Long-term government 1.0 Short-term invest grade 0.9 Ultra-short-term 0.8
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Source: Morningstar Inc.
