The Mutual Fund Mess

Lousy returns, lumbering giant firms, too many funds--can the industry right itself?

Retired New York broker Marilyn Male is down in the dumps. Her investment in Baron Asset Fund has lost 17% this year. In three years, the $3.4 billion fund has earned a measly 2.5%--less than she could have made in a plain-vanilla money-market account. Outside the New York Grand Hyatt's Empire State Ballroom, Male is in no mood to join the 2,000 shareholders boogying to a Motown band, wolfing down shrimp cocktail, and cheering patriotically as Liza Minnelli belts out New York, New York at Baron Funds' recent shindig. "`Am I concerned?' isn't a good question," she grumbles. "`Am I thinking about never buying another mutual fund again?' is a better one."

No doubt about it, America's long romance with mutual funds is on the rocks. The industry rode a decade-long bull market and a booming retirement business so well that it managed a record $7.5 trillion of assets--nearly as much as Europe's annual gross national product--by the end of 2000. Since then, the industry has been in free fall. Assets have tumbled 12%, to $6.6 trillion. The carnage in stock funds--the biggest money-spinners for management companies--is far bloodier: Assets have slumped 20% this year, to $3.1 trillion, while net new sales are off by 95%. The 77-year-old industry has endured three of its biggest-ever one-month outflows from equity funds this year, a bigger cash drain than even in the 1987 stock market crash. More than half of all U.S. fund companies have seen more money head out the door than come in, says Boston's Financial Research Corp. "Everybody's boat is sitting on the bottom right now," says Daniel T. Geraci, CEO of Boston's Pioneer Investment Management USA Inc. "The tide went out for all of us."

The mutual-fund industry is in a real mess. It's struggling with the huge burden of overcapacity it created by setting up thousands of new funds and hiring hundreds of high-priced managers to capture America's savings. With stock values crashing and investors deserting their funds, profits of the fund groups have collapsed under the weight of their outsize costs. Even more pain awaits, as a corps of smaller, low-cost funds with smart managers and decent returns starts to compete head-on with the behemoths.

FIZZLERS. Perhaps even more ominous is how the industry has damaged the very core of its business: investors' belief that the funds could produce superior returns at low cost while protecting them from untoward risk. Those investors still hanging on may be in for even more bad news as the funds scramble to cut costs. The coming wave of consolidation could throw many investors into mediocre funds with no clear mission. Many of the funds may raise fees and insist on bigger minimum investments to bolster their shrinking margins.

For years, the mantra of the industry has been "sell, sell, sell." Build a huge machine to muscle into every brokerage office and onto every household computer screen, the thinking went, and success would follow. Instead, the fund companies' credibility--and investors' trust--went out the door. In a rush to scoop up every last investment dollar in the 1990s, fund firms bombarded investors with nearly 6,000 funds, many of them mediocre. They pumped out funds specializing in hot sectors that quickly fizzled. Scores of now-defunct Internet and tech funds hit the streets even as the bull market sputtered. Sure, fund ads dutifully warned that prices could go down as well as up, but only winning funds are ever promoted. And until the Securities & Exchange Commission clamped down, the companies routinely invented snazzy fund names to pique investors' interest, though stocks they invested in bore little relationship to the title or the risks of the fund.

All the hype created a situation in which the hopes and expectations of 93 million fund investors were bound to be dashed. Trouble is, mutual-fund managers and other investment pros such as pension-fund managers judge their performance exclusively in relative terms--by measuring how well they do compared with a benchmark such as the Standard & Poor's 500-stock index. If the index is down 13%, as it is so far this year, they're heroes if they're only down 11%. That's phooey to most ordinary investors, who want to see their wealth expand in absolute terms and not simply get poorer slower than their neighbors. Even in this year's stock-pickers' market, more than half the managers are failing to beat their bogies.

TOXIC FUNDS? The few successful managers increasingly come from the hundreds of boutique firms running small funds most investors have never heard of. The $46 million Aegis Value Fund, for instance, is up over 36% this year and has trounced both its peers and the S&P over the past three. Aegis and its ilk are starting to eat the behemoths' lunches. And increasingly, they're drawing business from institutional investors such as pension funds. For example, Strategic Investment Group (SIG) is placing $40 million with entrepreneurial portfolio upstarts to manage on behalf of the $151 billion California Public Employees' Retirement System, the world's second largest. SIG Chief Executive Hilda Ochoa-Brillembourg says big brand-name funds are a potential "toxic-waste site" for the baby boomers' retirement hopes. "All I see in their future is downside risk and very little upside potential," she says.

Twisting the knife in the wound, big fund companies are charging investors royally for lackluster results. They take $1.54 in fees for every $100 invested in equity funds, up nearly 14% since 1993, according to mutual-fund tracker Lipper Inc. Given that the costs of running funds don't rise much as assets grow, fees should be steady or even falling. To add insult to injury, some fund groups that have lost scads of money for investors are sticking them with extra charges--because the value of their accounts has sunk below the minimum investment. T. Rowe Price Associates, Dreyfus, Fidelity, and Zurich Scudder Investments impose such penalties. Others, including Franklin Resources, are even raising the minimum. Apart from being stuck with those charges, some investors with big losses face steep tax bills--for capital gains on stocks bought months or years before they became shareholders.

Today, billion-dollar outfits are "questioning their survivability," says Steven E. Buller, Ernst & Young's national director for asset management. "Fund complexes large and small will rethink being in the investment-management business at all." The be-everything-to-everybody business model of giants such as Fidelity Investments, Dreyfus, Putnam Investments, and T. Rowe Price is showing serious chinks. However, most giant fund families are in denial. Richard A. Spillane Jr., head of domestic equity at FMR Corp., parent of No. 1 Fidelity Investments, says investors get a "good deal at pretty reasonable fees with a lot of liquidity." He agrees that scale doesn't guarantee success, but it "improves your odds of delivering the performance," he says. "It allows us to have a 500-person equity staff spread all over the globe. It allows us to have arguably the best trading department on Wall Street." Yet few of Fidelity's investors are likely to be as sanguine as Spillane: A third of Fidelity's U.S. diversified equity funds are lagging their peer group this year and for the past three years, according to fund researcher Morningstar.

"COMPLACENCY." Indeed, few companies have faced up to the new reality by cutting staff, trimming offerings, or nixing expansion plans. Many fund execs still earn more than Wall Street tycoons: Mario J. Gabelli of Gabelli Asset Management Inc. raked in $45.5 million in 2000, while Lawrence J. Lasser at Marsh & McLennan's Putnam Funds pulled in $35.2 million, including options and other cash payouts. The median portfolio manager will earn about $436,500 this year, 35% more than in 1999, according to headhunter Russell Reynolds Associates. In fact, expenses will grow faster than revenues for the third straight year as a result of hefty paychecks: Employee expenses account for 70% of operating outlays, says Capital Resource Advisors, a Chicago financial-services consultant. Overall operating margins, while still a heady 35%, are 16% less than two years ago. "Most big fund companies are hurting. Their talent is leaving. Combine that with complacency, and we're in for a remarkable transition like we've never seen before," says Christopher J. Acito, managing director of financial services for Barra Strategic Consulting Group.

What's in store? Monolithic, one-stop fund companies must come to terms with what they've become: huge marketing machines and rather indifferent money managers. Their best hope may be to buy portfolio management from specialists to boost their sickly performance, as American Express Co. did recently when it hired Mario Gabelli, Pilgrim Baxter & Associates, and Wellington Management to run a smattering of new funds. But they'll also have to restore confidence. That means, for example, closing large funds before the volume of new assets swamps performance. And if a fund fails, they will need to return money to investors rather than merge the fund into something remotely similar, just to keep the account. Some outfits have gotten the message already. When it liquidated its $500 million Longleaf Partners Realty Fund in November, Longleaf Partners gave back what remained to investors, saying the shrinking market in real estate stocks was too small to make profits.

Investors aren't just fleeing weak markets and poor performance--they're searching for sophisticated, custom-fit investments. Mercer Manager Advisory Service reports that $9.3 billion went into competing alternative investments, such as hedge funds and private-equity partnerships in the first half of 2001, up from $4.8 billion in the first half of 2000. "Investors are so disappointed with performance that they're thinking, `By God, if I'm going to spend money in this environment, I want smarter managers,"' says John Markese, president of the 170,000-member American Association of Individual Investors in Chicago. "I don't know that the mutual-fund industry can deliver."

The mutual-fund giants had better learn fast if they're to tap the fastest-growing, most lucrative slice of the U.S. population: people with $5 million or more to invest. Already, there are 400,000 of these affluent households, and Goldman, Sachs & Co. figures that number will grow 18% a year through 2004. Financial Research adds that over the next three to five years, as much as 50% of the $1 trillion in mutual-fund assets owned by the affluent will switch to so-called separate accounts. These custom-made products invest in individual stocks and some pure-play sector funds and charge a fee based on the assets. They offer what mutual funds do not: more transparency and tax-efficiency.

If they're not careful, mutual funds could start to lose their stickiest assets--401(k) retirement funds. With Americans aging and changing jobs more often, rollovers are forecast to explode. It's not unusual for such accounts to reach $1 million now--and to head to banks or brokerages' individual retirement accounts, siphoning assets from fund firms. In 1999, the $2.5 trillion IRA marketplace, in which the fund industry lacks servicing skills, surpassed 401(k) assets for the first time. "It's a potential minefield," adds Consultant Kurt Cerulli of Boston's Cerulli Associates Inc. "It's a market more about advice and guidance. Fund dollars are starting to shift."

CATCH-UP. And fund companies are out of the loop: The top five New York brokerages--Salomon Smith Barney, Merrill Lynch, Morgan Stanley Dean Witter, Prudential Securities, and UBS PaineWebber--collect 70% of the $275 billion separate-account business. Even though fund firms manage many of the underlying portfolios, brokerages capture the lion's share of management fees. With the market forecast to triple, to $730 billion, by the end of 2005, fund companies are playing catch-up with strategic acquisitions. This year, Eaton Vance acquired Fox Asset Management, while Legg Mason bought Private Capital Management in Naples, Fla., to gain a toehold in the high-net-worth market.

Others are moving fast to get into hedge funds, which pulled in a record $22.3 billion in the first three quarters of 2001, vs. $8 billion last year. Immediately after his appointment in July, John V. Murphy, CEO of $115 billion OppenheimerFunds Inc., which earns 95% of revenues from mutual funds, bought Tremont Advisors Inc., manager of $8 billion in hedge-fund accounts. Two new funds, with $50,000 minimums, will be launched in January for high-net-worth investors. "We want to grow faster than what the mutual-fund business is going to give us," says Murphy.

Of course, not every firm needs to be an upmarket distributor. There's still room for the low-cost provider, such as Vanguard Group whose 52 equity funds have expenses averaging 0.32%, vs. over 1.5% for the industry. Through September, Vanguard has collected some $26.2 billion of net new money, almost double the $14.3 billion in the same period last year. "Our business has been quite robust since the silliness on the stock market ended in April of last year," says CEO John J. Brennan. Still, Vanguard isn't resting on its laurels. When the Malvern (Pa.) company was threatened by exchange-traded funds (an alternative to mutual funds that trade like stocks on an exchange), it developed its own ETF product line, including the Vanguard Total Stock Market VIPERS, which tracks the broad Wilshire 5000 index. To hold on to the $700 billion it has under management already, it is developing a private-equity investment program for wealthy clients and rewarding long-term investors with charges as low as 0.12% of assets.

Few fund companies could live with such low fees. But they don't have to. Their best hope of restoring their fortunes is to brace for a decade of slower growth in which enriching their clients should be top priority. Their worst tactic would be to sit back and wait for the markets to recover--and the money to start rolling in again. It may well not.

By Mara Der Hovanesian, with Lewis Braham, in New York

— With assistance by Lewis Braham

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