Mutual Fund Houses Start To Hear Footsteps

For much of the 1980s, banks watched somewhat helplessly as mutual-fund houses and brokerage firms siphoned off their customer deposits into money-market funds. By the mid-1980s, banks were bolstering ties with their customers by forming partnerships with mutual-fund houses and inviting them into their branches to sell a wide array of funds. Now, banks are taking a step that could have ominous consequences for the mutual-fund industry: They are rolling out their own in-house funds and starting to go head to head with established funds.

So far, the industry doesn't seem to have much to lose sleep over. True, more than 100 banks offer some 460 different proprietary mutual funds, up from 113 offerings in 1986 (chart). And bank funds have assets of more than $65 billion, more than double the amount five years ago. But those numbers pale next to the $1.4 trillion in overall mutual-fund assets and the overall universe of about 3,500 funds.

The battle, however, is still in the early stages. In recent months, banks have been stepping up their marketing efforts. As the yields on certificates of deposit decline, bankers see offering their own mutual funds as a way to maintain a relationship with customers they might otherwise lose to competitors. "When banks offered money-market accounts in 1982, we had substantial outflows," says Donald E. Farrar, an excecutive vice-president with Benham Management Corp., which runs $8.5 billion in mutual-fund assets. "We take bank competition very seriously."

Banks have a key strategic advantage: the unparalleled power of their distribution network. Some fund groups say that 20% to 30% of their sales are made through bank branches.

`RUBE GOLDBERG WAY.' Yet banks suffer from a serious handicap, stemming from the Glass-Steagall Act of 1934, which erected barriers between commercial banking and most investment functions. While banks can manage fund portfolios, they can't underwrite or distribute mutual funds. "Banks have a tremendous customer base," says Carl Frischling, a securities lawyer with Spengler, Carlson, Gubar, Brodsky & Frischling in New York. "The key question is how can you get to it legally, and how can you service it?"

To comply with current law, banks have had to devise a variety of circuitous and cumbersome arrangements. "It's like saying the mutual-fund industry gets to drive its car directly, and the banking business has to drive with three sidecars and operate in a Rube Goldberg way to do the same thing," notes banking consultant Edward E. Furash, president of Washington-based Furash & Co.

Yet these arrangements haven't materially hampered determined bank fund sellers. Take Citicorp, which markets its own Landmark Funds. Citi manages the funds' portfolios. But it uses an unrelated firm, Landmark Financial Services, to underwrite and distribute the funds. Initially, the bank used employees of Landmark to sell the funds in Citi's branches. Last spring, it took more direct control of the sales effort by putting 140 Landmark brokers on the payroll of a Citi subsidiary.

Currently, Citibank is mounting one of the most successful and aggressive fund-marketing campaigns by a bank. In the New York City area, where the campaign started, Citi's Landmark funds pulled in $800 million in assets from last April through December to reach the $2 billion mark. That's in contrast to the $1.3 billion runoff in Citi's $19 billion portfolio of CDs. An additional $850 million flowed into the other 650 competing mutual funds that Citi makes available--and even advertises in branch windows. Citi is expanding its marketing of the Landmark funds into California, Chicago, and Washington, D.C.

The banks' chief goal in hawking in-house funds is to keep customers from moving their assets to other investment-product vendors. "If someone has their checking, auto loan, and investments with the bank, there's not a wedge that can be driven by a Merrill Lynch broker with a cash-management account," says Jeremiah M. Potts, vice-president for banking-industry marketing at Massachusetts Financial Services Co.

As their major selling point, banks are stressing their objectivity and reputation for integrity, as compared with other purveyors gf financial services. "Bankers are not viewed as used-car salesmen, trying to hustle customers into just the products that they want to sell them," notes Furash.

Citi insists that the bank's mutual-fund campaign doesn't make a distinction between proprietary funds and outside funds. Bank of America also stresses that while it is widening its stable of in-house funds, which have assets of $1 billion, they are just part of the investment buffet. "If we can't offer the performance and service that other funds offer, then we shouldn't be given `favored-nation' status," says Donna J. Knight, vice-president and manager of investment-product development.

But the temptation to encourage the sale of in-house funds is strong. "Some banks are falling into a trap by insisting on selling just their proprietary funds," says Furash. "Unless those funds have a great track record, then they're trying to hustle consumers into a subpar product." Loren Smith, Citi's head of New York marketing, concedes that "if we sell a Fidelity fund, we may make 3% on a onetime sale, and then the money is gone. If, say, we got the Landmark fund up to $3 billion, we would make 0.5% to 0.6% on the whole kit and kaboodle as long as it's there."

SMALL THREAT. Some regulators also worry that, in promoting themselves as trusted advisers, banks may give consumers the impression that money in house-brand funds is protected by deposit insurance. "To the extent that these securities are being sold by banks or on bank premises, we continue to be very concerned about depositor confusion," says Bob Miailovich, assistant director of supervision for the Federal Deposit Insurance Corp.

The mutual-fund industry's reaction to the banks' house-brand funds is, so far, muted. While Benham's Farrar is worried, most fund companies seem to perceive little threat. Some fund companies such as Fidelity Investments are actually helping banks set up their house-brand funds. "In general, I don't see the logic of banks being in the fund business," says John Bogle, chief executive officer of the Vanguard Group. "What can they contribute that we can't? Better service? Lower prices? Better performance? That would be difficult."

Bogle has a good point. Yet many seasoned bank observers suggest that it could be very dangerous for the established mutual-fund industry to remain complacent. Says Lowell L. Bryan, a banking consultant at McKinsey & Co.: "Toward the end of the decade, as truly national banks emerge, I would expect some big national banks to be very serious competitors to the traditional fund groups." The once comfortable partnership between banks and fund companies seems certain to become increasingly contentious.

    Before it's here, it's on the Bloomberg Terminal. LEARN MORE