With a possible war with Iraq looming and a spectacular terrorist catastrophic follow-up embedded in the consciousness of many investors, the mutual fund market appears cloudy, at best, for 2003.

Great unknowns aside, there are some noticeable changes bubbling to the top as the year comes to a close, sure to change the industry landscape in 2003.

Oct. 9 Called the Bottom

Setting the stage for 2003 was Oct. 9, a date many are calling the bottom of the bear market. The S&P 1500 Super Composite Index likely bottomed on that date, according to Standard & Poor's, New York. However, that does not mean it's party time for the industry. Many are predicting a slow crawl upward in 2003, or a possible stagnation.

Don Cassidy, a senior analyst with Lipper of New York said a combination of slow growth and the cautious mentality of today's investor leads him to expect the 2003 mutual fund year to be a "battle for market share."

"We'll still see some drains in money market funds, and bond fund flows probably won't be as strong as this year," said Cassidy, saying that the industry could, however, see modest inflows in 2003.

"On the equity side, flows should be fairly modest; people aren't going to regain confidence and come back with buckets of money real quick."

Even so, he thinks value may do "a little better than growth" because there's a lot of large-cap stocks that are of the growth variety and their price to earnings ratios, or P/Es, are "fairly generous." He also expects small- and mid-caps to do better than large-caps and sees no reason bond funds have to go down or that interest rates have to go up.

Fund companies will also face the challenge of retaining money. "In the money market fund area, we've been having some outflows, and that's certainly attributable to rates. Once the money goes away and goes into a three or four year CD, the industry is going to have to fight to get it back." [See MFMN 9/9/02.]

Meanwhile, he anticipates smaller firms will look to merge with larger partners and companies continuing to ditch funds that aren't keeping up to snuff.

Temporary Help

Discipline seems to be the key word for 2003, as companies are jockeying for position to make gains on the limited playing field that has taken shape over the course of the bear market.

Kim Raynor, an associate at executive recruitment firm Russell Reynolds, New York, expects to see "opportunistic hiring by a handful of mutual fund companies looking to upgrade their existing talent base." She said they will be looking to make manager changes and grab market share, while shoring up existing management teams.

"We don't expect wholesale hiring to be going on because of the market," she said. "Margins are being strained. Fixed costs have been adjusted down with considerable layoffs." Hiring will be in select areas of the mutual fund market, Raynor said.

George Wilbanks, managing director at Russell Reynolds, said that companies such as PIMCO, which have done exceptionally well in 2002, may look to add staff, while others that have struggled, such as Janus, will not expand their employee base.

Wilbanks said an expected "lackluster performance" from the markets in 2003 should dictate staffing levels.

"If the markets don't improve, you're unlikely to see a hiring rebound."

Cassidy agreed, saying it is likely outsourcing will play a role as part of the overall consolidation and companies working to get costs "as skinny as they can be." Cassidy also expects companies to use temp agencies for call centers, instead of hiring new permanent employees.

Lisa Cohen, a marketing consultant based in Medfield, Mass., said that with corporate purse strings remaining tight, she has not heard of anyone increasing their advertising budgets significantly for the coming year.

However, she has seen signs of life and expects advertising to be even with last year's levels, or slightly better. "Advertisers have had to figure out how to get into the psyche of investors. You'll start to see stuff more like what we used to see - but focusing less on returns."

Fixed-Income Train Wreck

Douglas Kreps, a portfolio manager with Fort Pitt Capital Group of Pittsburgh, said that 2003 is a year in which the market may just simply tread water, but warned of disaster in select corners, should inflation arise.

Kreps, who said he is responsible for over $130 million in mutual fund-based asset allocation accounts for high-net-worth individuals, thinks the possibility for a "train wreck in the fixed income market" is present in 2003.

Yields are low now, and there is not a lot of margin for error if inflation lifts, Kreps said. "We could be in for an awful surprise," he said.

And if there is a military conflict and the operation does not go as smoothly as Desert Storm did in the early 1990s, oil prices could soar and, in turn lead, to inflation. "We could see negative returns on bond funds next year and that would scare a lot of investors," Kreps said.

Fund Filings

Another significant harbinger of the year to come is the fact that the number of new funds to be offered in 2003 is significantly down, dropping nearly 60% from 2000, according to data obtained from Strategic Insight, New York.

In 2000, there were 1,157 new fund filings, with 950 of those equity funds. In 2001, there were 671 new fund filings with 523 of them equity fund filings. In 2002, there were 467 new fund filings year-to-date, with 317 of those equity funds. Overall, equity fund filings are down 67% from 2000 levels.

"One of the biggest changes in 2003, if current trends continue, is that investors and consultants are starting to realize they will have to live with a degree of uncertainty and allow for flexibility," Kreps said. "Consultants are showing more patience towards managers and allowing more drift, because you cannot beat the market if you look exactly like the market."

Pessimism is lessening, according to Kreps, and investors are starting to understand that the terrorism threat will not just disappear. "You have to build that into your expected return assumptions when you construct your portfolio, and you have to just deal with it. We have a new terrorism premium in the market."

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