Economies cycle, investment markets alternate from bull to bear and the tides ebb and flow. For mutual funds, 2008 was the year of the ebb tide: Long-term funds (excluding money market funds) saw net outflows of $226 billion, according to the Investment Company Institute (ICI), paced by huge redemptions of stock funds in the second half of the year. The carnage continued in the first quarter of 2009, when an additional $43 billion flowed out of equity funds.

Although virtually all types of investments have suffered recently, mutual funds face more ingrained problems. "Equity funds have underperformed, while bond funds are expensive, relative to yields," says Chip Roame, managing principal of Tiburon Strategic Advisors, a financial services research firm in Tiburon, Calif. "In addition, mutual funds face increasing competition from separately managed accounts and especially from exchange-traded funds." In May, San Francisco-based Grail Advisors introduced the first actively managed ETF. And the one type of mutual fund that has remained popular during the market downturn—target-date funds—is under new regulatory scrutiny for its disastrous performance during the recent recession.

MAKING A COMEBACK

Despite such concerns, money can quickly flow back to mutual funds on good news. As of this writing, stocks have bounced from what may prove to be a bear market low in early March. Flows have rebounded too. ICI reported nearly $80 billion in net inflows in April and early May of this year, with almost $25 billion going into stock funds.

During this mini-bull market, bond funds are outdrawing equity funds by about two to one. Treasury bond funds have maintained their appeal, after a strong showing in 2008, while muni bond funds and high-yield bond funds have enjoyed record inflows this year.

On the equity side, domestic stock funds are getting proportionately more inflows than international funds, according to Robert Bruno, president of First Eagle Funds Distributors in New York. Investors' recent preference for U.S. stocks may be partially due to the perception that foreign stocks are risky, he says, and partially due to the belief that the United States went into a recession before the major foreign economies, so its economy may be the first to recover.

In addition, flows seem to be favoring growth funds over value funds, according to Bruno. "Some leading value funds disappointed investors last year," he says. "They were heavily invested in financial stocks, and some bought financials after they dropped, only to see them drop even more." Growth sectors, such as technology, often do well in an economic rebound; besides, after last year's crash many stocks in traditional growth industries are now value priced.

Nearly $80 billion flowed into long-term mutual funds in seven weeks, so most fund firms have had reason to smile. Nevertheless, some companies are better positioned than others. "Of the publicly traded fund firms we track, a few had positive flows in the first quarter of 2009," says Darlene DeRemer, co-founder of Grail Partners, a Boston-based merchant bank specializing in the investment management industry.

DeRemer names J.P. Morgan for its strength in fixed income; Invesco, which owns PowerShares ETFs; T. Rowe Price for overall good performance; and Federated Investors, with a substantial presence in money market funds (money funds had huge inflows in 2008). Non-public fund companies with similar strengths-fixed income, money funds, ETFs-also may be well-positioned now. In addition, DeRemer believes that providers of low-cost index funds, such as Vanguard, may benefit from increased popularity when the economy recovers and investors regain confidence in mutual funds.

TRYING TO SURVIVE

If an economic recovery is joined by a stock market surge, most mutual fund companies are likely to prosper. The 2000 to 2002 bear market, similar in depth to the current slide, was followed by five straight years of virtually uninterrupted gains. Equity fund assets shot up from $2.7 trillion to $6.5 trillion from year-end 2002 to year-end 2007, indicating that these funds benefitted from substantial net inflows as well as from the growth of the stocks they held.

For now, mutual fund companies appear to be preparing for hard times. "The industry is undergoing significant consolidation," DeRemer says. "Product lines are being rationalized, share classes are collapsing and acquisitions are likely. There are too many mediocre sponsors now. We may be heading toward a meritocracy, where the better fund companies are the survivors."

Those survivors might be ready to profit from another bull market. "While the industry has been laying off employees, most of the cutbacks seem to be in the back office," says Karen Dolan, director of fund analysis at Morningstar. "The companies generally have kept their investment professionals, including people in research." If stocks come back, and if those researchers can consistently beat their benchmarks, equity funds may experience a rerun of the mid-2000s.