Mutual Funds: Back In Action
At the peak of the last bull market, Orlando (Fla.) accountant Ingrid Goldberg, now 58, had most of her money tied up in high-octane growth stock and sector-specific technology mutual funds. Boston's Patrick Monaghan, now 31, was just getting started in his management consulting career. He sunk what little he had -- $10,000 -- into the fashionable stocks of the day, Cisco Systems (CSCO ) and Dell Computer (DELL ), even though his grandfather had been a mutual fund manager and his family urged him to use funds.
Goldberg and Monaghan don't have much in common except that they both got burned when the stock market cratered from 2000 to 2002. And both are relying on mutual funds, with the help of financial advisers, to restore their fiscal fitness.
So far, so good, even with the recent slide in stock markets around the world. "It's worked out really well now that I'm diversified," Monaghan says. "I'm up by leaps and bounds," says Goldberg, who plans to retire in four years. "The future looks bright." In fact, the future looks a whole lot brighter for many of the 91 million people who invest in mutual funds.
Sure, exchange-traded funds (ETFs) and hedge funds seem to be grabbing all the headlines, and they are also attracting plenty of new cash. But in their own quiet way, mutual funds are pulling in the big bucks. In 2005 they took in $255 billion in net inflows and nearly $145 billion through April. Since then, though, investors have pulled out $6 billion -- mainly from international mutual funds, according to AMG Data Services, a fund tracker in Arcata, Calif.
So much for the death of mutual funds, an often-heard pronouncement just a few years ago. That was when the funds were suffering a double whammy from the dot-com bust market and a trading scandal that involved more than a dozen companies. In 2003, in fact, investors pulled more cash out of funds than they put in for the first time in more than two decades.
Today, mutual fund assets have swelled to an all-time high of $9.5 trillion, up from nearly $7 trillion in 2000. While critics have griped for years that they fail to beat market indexes, mutual funds are doing a much better job for shareholders. They outpaced the stock market from 2002 to 2005, with the average stock fund earning 16.9%, as the Standard & Poor's 500-stock index rose 15.2%, according to S&P, which, like BusinessWeek, is owned by The McGraw-Hill Companies (MHP ).
It's also getting cheaper for investors to own mutual funds. Fees have declined for two years in a row, according to a new study from Morningstar (MORN ), the Chicago fund tracker. At the same time, more fund families are taking steps to protect shareholders, including closing funds to new investors to maintain performance and adding redemption fees to discourage churning.
The most surprising news of all: Investors seem to be getting smarter, finally, about the kinds of funds to buy, and they're holding on to their fund portfolios for longer periods, which translates into better returns. Throw in some more regulatory scrutiny, and mutual fund investors are better off today than they were six years ago, says Morningstar Managing Director Don Phillips. "Good things are happening on many fronts," he says. "The fund industry has learned a lot of lessons from the collapse of the stock market bubble and the mutual fund scandals."
Those scandals sent investors fleeing from many fund families that got ensnared, including Janus Funds (JANSX ) and Putnam Investments (MMC ). At the same time, record sums are gushing into untainted firms such as Capital Research & Management's American Funds, Fidelity Investments, and Vanguard Group.
To be sure, thorny issues remain. Critics say changes are needed in the way funds are sold, arguing that advisers and brokers are recommending funds more for the commissions they pay them than for the performance shareholders receive. Supply is a problem, too: With nearly 9,000 mutual funds to choose from, there are simply too many funds, resulting in higher costs and less oversight. In theory, industry consolidation should wipe out bad funds and replace them with better options. That doesn't always happen. When Wells Fargo acquired Strong funds, some gimmicky portfolios, including Strong Dow 30 Value, were merged out of existence. But performance in other funds, such as the Wells Fargo Advantage Balanced Funds (formerly Strong Balanced) have failed to impress. "Are things better [for shareholders]? Maybe a little bit," says John Bogle, founder of Vanguard Group and a champion of investing in low-cost index funds. "Is it good enough?" asks Bogle. "Not within miles."
As always, performance still drives fund flows. In recent weeks the stock market swooned, and more than $6 billion flowed out of U.S. stock funds from May through early June, according to AMG Data Services. While it may make Bogle cringe that investors still think they can beat the market, more money went into actively managed mutual funds than into exchange-traded funds and hedge funds combined last year. "That shows investor confidence in mutual funds as an investment vehicle," says Philip Edwards, managing director at S&P Portfolio Advisors (MHP ).
Of course, over longer periods, funds still lag behind the S&P 500. Typical stock fund investors gained an annualized 5.8% in the past decade, vs. 9.1% for the S&P 500, according to Dalbar, a Boston financial-services consultant. That's because they often do not buy a fund until it has already done very well. Dalbar adjusts returns to reflect that behavior. As a result, over the 20-year period, fund investors gained just 3.9%, vs. 11.9% for the S&P.
What has helped investors gain a bit of a performance edge in more recent years, though, is a reduction in fees. You can thank Eliot Spitzer for some of those lower mutual fund costs. The New York Attorney General's probe into market timing and late trading practices by fund companies in the summer of 2003 resulted in settlements that cut mutual fund fees. The typical individual investor in funds paid 0.93% in expenses for a U.S. stock fund in 2005 -- or $93 for every $10,000 invested -- compared with 0.99% in 2004, according to a Morningstar study. Research just released by Investment Company Institute (ICI), the fund industry's trade group, comes to similar conclusions. Those may not look like huge cuts, but they are significant because fund fees fall ever so slowly.
Investors are taking notice of those fees. Tom Meyer, a Marlton (N.J.) financial adviser, sends fund fact sheets to his clients, and they're increasingly paying attention to costs. "My clients are becoming cognizant of fees -- not as many as I would like to see -- but many more than I have seen in my 24 years," says Meyer.
Another big surprise: Fund investors seem to be less trigger-happy. According to Dalbar's research, investors are holding on to their fund portfolios for an average of 4.3 years, vs. 2.7 years in 2001. That's because more funds are being sold through advisers, which means money is more "sticky" -- it stays put rather than chasing hot performance. A recent ICI study found that 73% of investors surveyed consulted an adviser before they purchased a mutual fund. "People are smarter than we give them credit for," says ICI President Paul Schott Stevens. Nearly three-quarters of fund investors surveyed wanted to know about the fund's fees and expenses prior to purchasing shares, and more than two-thirds reviewed or asked questions about the fund's historical performance.
At the same time, advisers aren't just cramming the product du jour down their clients' throats. They are doing a better job of managing money and charging flat fees for service rather than relying on commissions. "That's a striking change in the industry landscape," says East Greenwich (R.I.) fund consultant Geoff Bobroff. Those financial pros deserve some credit for changing their stripes. "More advisers get the message that diversification is important," says Keith Singer, a financial adviser in Boca Raton, Fla. As a result, investors are pouring cash -- more than $21 billion so far this year -- into asset allocation funds, according to Financial Research, a financial-services firm in Boston. The beauty of these portfolios is that they offer a predetermined mix of stocks, bonds, and cash.
Among the most popular are target- maturity funds, a fund-of-funds portfolio that comes with an expiration date. These funds offer one of the simplest ways to diversify. For example, let's say you're planning to retire in 2025. You buy a fund with a 2025 target date. As you approach the target date, the fund's asset mix shifts from more aggressive stocks to conservative holdings of bonds and cash. Overall, asset allocation funds account for 26% of new fund sales, up from 2% in 1999. Once investors buy into these funds, they rarely sell them. "Retention periods dramatically increase with asset allocation funds," says Dalbar President Louis Harvey.
ICI's research shows that the typical fund investor doesn't seem to care much about fund governance, but the fund scandals left an important legacy in the way funds are run -- and that benefits shareholders. While fund boards were once seen as wielding rubber stamps, at least a few are now taking an activist stance. Perhaps the most notable display of independence is how the board that governs Clipper Fund, managed by a unit of Old Mutual Asset Management, reacted when veteran manager James Gipson and two colleagues departed at the end of last year. Instead of automatically approving Old Mutual's chosen replacement, the board conducted its own search and hired Davis Selected Advisors, which specializes in value stocks, as Clipper's new manager. "In the fund industry everyone is on their best behavior," says Morningstar's Philips.
Best behavior can lead to some best practices. Since 2000 more than 300 funds have been closed to new investors, according to Morningstar. Fund closures are good for existing shareholders because a torrent of cash can overwhelm the managers, resulting in bad decisions as they scramble to put the money to work. Noteworthy funds that have shut their doors so far in 2006 include Fidelity Japan Smaller Companies (FJSCX ) and Fidelity Contrafund.
Mutual funds may be turning away new investors, but new exchange-traded funds are beckoning them. There are 250 or so ETFs now available to investors, and even more are in registration at the Securities & Exchange Commission. Such funds are bought and sold like stocks. The best ETFs offer a low-cost way to track the major market indexes, such as the S&P 500. But now a slew of sector-specific ETFs are being rolled out, including ones that focus on silver, oil, medical devices, and home construction. On June 16, Wisdom Tree Investments, which is run by former hedge fund manager Michael Steinhardt, Wharton School professor Jeremy Siegel, and Jonathan Steinberg, who owned the now-defunct Individual Investor magazine, launched 20 exchange-traded funds. (Steinberg is married to BusinessWeek columnist Maria Bartiromo.)
The frenzy to introduce new ETFs reminds New Jersey adviser Meyer of 1999, when a cascade of technology funds came to market. "It's downright scary," he says. Although ETF assets doubled in the past 12 months through April, the $385 billion invested in these funds is still a puny share -- about 4% -- of what's in traditional mutual funds.
The giants of the fund industry are moving quickly into the ETF market. AMVESCAP, which owns AIM Funds, is acquiring PowerShares Capital Management (AVZ ). The exhibit hall of the recent Investment Company Institute conference was teeming with venture capitalists looking to get on the exchange-traded bandwagon, says Morningstar's Phillips. "The amount of people trying to make money from ETFs is worrisome," he says.
At least for now, fewer investors are speculating on mutual funds, and they're making smarter investment decisions. "The public got burned by the scandal, and the market learned a lesson, but how long will they retain that lesson?" asks Burton Greenwald, a mutual fund consultant in Philadelphia. While memories tend to be short, investor interest in mutual funds is here to stay.
By Lauren Young