WASHINGTON - Mutual fund companies may be attracting big assets now, but other investment tools are giving the $9.5 trillion industry a run for its money.
Product innovation among separately managed accounts, closed-end funds and hedge funds have made the once off-limits options increasingly popular among financial planners.
But perhaps the most direct competitor to traditional mutual funds, the increasingly popular exchange-traded funds, saw a 51% spike in assets under management in the 12-month period through April 30, according to data from the Investment Company Institute of Washington.
"If I were a mutual fund company, I would be scared," said James H. Lee, a financial adviser and coordinator for the consulting group at New York-based Smith Barney.
While many of these products have, in recent years, begun to gain traction as complementary investment tools, ETFs in particular are poised to erode mutual finds' massive market share, said panelists at the Investment Company Institute's General Membership Meeting, held here last month.
Closed-end funds typically work best as a small slice of an investor's portfolio, said Dawn J. Bennett, chief executive officer of Bennett Group Financial Services. "There's not too much volatility, and we use the income," the Washington-based money manager said. "It has turned out to be a good move," she added, citing how meager interest rates in the last six years have investors hunting for low-risk returns. Bennett suggested clients put a tenth of their portfolio in closed-end funds and reinvest the gains. Rather than buy on the initial public offerings, Bennett prefers to buy on the secondary offering, thereby allowing time to track performance, she said.
"It's proven to be quite a brilliant strategy," she said.
Hedge funds, likewise, can pump up a portfolio anchored by mutual funds, said Jeff Leventhal, a senior vice president for investments at UBS Financial Services, who is based in Bethesda, Md.
"[Hedge funds] really take the handcuffs off," said Leventhal, describing the more aggressive long-short and arbitrage strategies used by the less-regulated second cousin of the mutual fund. And as hedge funds continue to try to compete with more mainstream products, minimum investments are dropping, making them accessible to a wider array of investors.
Acknowledging that many investors may associate hedge funds with high-risk investments, black-box strategies and deceitful managers who take investors' money and run, Leventhal recommended promoting only registered funds, those with longer performance records, and those that use a long-short strategy, which is easier to explain to novice investors than arbitrage.
With institutional investors investing more heavily in hedge funds, Leventhal asked, "Just because my client doesn't have a billion dollars, does that mean he should have a less diversified portfolio than the Harvard endowment?"
Hedge funds also can use strategies that insulate their assets from the ebbs and flows of the stock market. "Having something in your portfolio that makes money when the market goes down is something everyone understands," Leventhal said.
At the same time, it's important that investors be realistic with regard to what hedge funds can and cannot do. For example, investors should not choose hedge funds simply in hopes of realizing returns of 20% annually in good markets, and 10% in downcycles. "That's not reality," he said.
But it's also not realistic to expect that hedge funds can continue to launch indefinitely. After all, there is such a thing as market saturation, Lee said.
"Hedge funds thrive on inefficiencies in the market, and inefficiencies are finite," he added.
Like hedge funds, separately managed accounts once belonged only to the ultra-wealthy, but recently, new products have begun borrowing SMA philosophies and applying them to portfolios of the only reasonably well-to-do. Like mutual funds, SMAs are baskets of equities, but unlike mutual funds, they can apply a more restrictive style - for example prohibiting buying shares in a specific company - as well as better control for taxes and immediate transparency. With mutual funds, shareholders often must wait for a quarterly report to learn of a fund's holdings.
SMAs also allow unaffiliated managers to work together, said Lee, which means investors benefit from even more diverse strategies than a team-managed mutual fund.
"The benchmark is important," Lee said. But more important than just beating the benchmark, he said, is "to be significantly and permanently different."
Still, the biggest threat to traditional mutual funds comes from the advent of the exchange-traded fund, which typically is structured like an index fund, but can trade throughout the day like a stock. In general, the fees associated with ETFs are lower than those of mutual funds, too.
"ETFs are going to change the mutual fund industry in a major, major way," Lee said.
It's already started. As of April 30, ETFs represented $334.9 billion in assets under management, up from $296 billion in December. In that month alone, the ETF market grew 4.2%.
ETFs offer diversity, value, liquidity and tax efficiency, said Gregory D. Sullivan, president of Sullivan, Bruyette, Speros & Blayney. Because they are so liquid, ETFs are also valuable tools when turning over a portfolio, because they allow investors to stay in the market, but allow the freedom to move out at any time. Sullivan uses ETFs as the core of his clients' portfolios, with equities, mutual funds and other investment tools as satellites.
The challenge, said the McLean, Va.-based money manager, is for planners to justify to clients taking an advisers' fee for these almost auto-pilot investments. "You have to explain to clients what asset management does for them," Sullivan said.
ETFs quickly became popular among institutional investors, said Sullivan, who predicted that they will become increasingly critical to the retail world soon, and more widely accepted among advisers. The more advisers rely on these low-cost tools - often as little as nine basis points, compared to 50 for a mutual fund - the easier it will be to parlay the savings into a competitive advantage, by using the difference to provide greater service to clients while still undercutting the cost of a portfolio heavily comprised of mutual funds, Lee said.
"This is a highly efficient way to run a practice" Sullivan concurred.
In order to continue to compete, Lee said, "mutual fund companies are going to have to step up their game."
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