The mutual fund industry was far from an instant success.

Massachusetts Investors Trust, the first open-end mutual fund, took four months after it opened for business in March 1924 to make its first sale - six shares to a suburban Boston banker, according to a history of the fund which MFS Investment Management of Boston published in 1974. One year later, Massachusetts Investors Trust had a mere 200 shareholders.

Indeed, mutual funds as a whole were slow to catch on. With the exception of a boom in the 1960s, those outside the industry for a long time viewed the mutual fund industry as a small, sleepy place.

John A. Carey, portfolio manager of the 71-year-old Pioneer Fund of Boston, recalls how a lawyer friend in 1979 scoffed when Carey told the lawyer he had taken a job in the mutual fund industry.

"This was regarded as a real backwater," said Carey.

Not any more.

After a slow, uneven start, mutual funds have become ubiquitous in the U.S. More than 77 million investors now own a stake in the securities markets through mutual funds, according to the Investment Company Institute. The mutual fund industry has grown from the sale of Massachusetts Investors Trust's modest six shares 75 years ago to more than $5.5 trillion in assets.

Success was not inevitable. Luck and hard work account for the mutual fund industry's achievements.

"The growth of the business is much more due to favorable external factors than the internal brilliance of management," said A. Michael Lipper, chairman of Lipper, Inc. of New York. "The things that have worked in its favor are remarkable."

The theme of the ICI's general membership meeting this week - Continuing a Tradition of Integrity: Preparing for the New Millennium - will be forward looking. More than 1,000 industry executives will gather in Washington to hear prognostications about the future of mutual funds.

The industry's past, however, demonstrates its strengths, exposes its weaknesses and gives clues to its future. Mutual Fund Market News examined the history of mutual funds on the occasion of the ICI's meeting in an effort to identify key factors which have accounted for the mutual fund industry's success and which are likely to have an effect on its future.

The Bull Market

On Aug. 12, 1982, the Down Jones Industrial Average closed at 776.92. Despite a memorable but short-lived crash in October 1987, the market has gone up more or less steadily ever since. The Bull Market has created wealth both for individuals who invested in mutual funds and for mutual fund companies themselves.

"Prosperity has been good for everybody," said Elizabeth Bramwell, a portfolio manager who has been able to build an $800 million money management firm, Bramwell Capital Management of New York, in the past five years. "It has been good for artists. It has been good for musicians... It has been good for mutual fund companies."

Assets in the mutual fund industry generally have risen as the market has gone up. Mutual funds held approximately $297 billion in assets as of Dec. 31, 1982, according to the ICI. The total dipped slightly, to $293 billion in 1983, but assets have risen each year since.

Increasing assets under management in a business paid based on a percentage of assets under management, has made for a profitable industry. The average mean of pre-tax income margin for publicly-traded money management firms was nearly 32 percent from 1993 through 1998, according to a report last month by Putnam, Lovell, de Guardiola & Thornton, an investment banking firm of San Francisco. For privately-held firms, profit margins have in some instances exceeded 70 percent, the Goldman Sachs Group said in a report last year.

Today's prosperity is in stark contrast with the 1970s," a period which Barry Barbash, in a 1997 speech he made while serving as director of the SEC's Division of Investment Management, called, "The Woeful Years." The Dow Jones Industrial Average stood at 800.36 when the markets opened on Jan. 2, 1970. When the bell rang to close the New York Stock Exchange on Dec. 31, 1979, the DJIA stood at 838.74, an increase of about five percent in 10 years.

Mutual funds made even less progress than the DJIA. Excluding money market funds, mutual funds had net redemptions in seven of the 10 years from 1970 through 1979, according to the ICI. Stock and bond fund assets under management essentially stood still during that same period, inching up $48.3 billion on Dec. 31, 1969 to $49 billion ten years later. Low-margin money market funds, which did not exist in 1969, had $45.5 billion in assets as of Dec. 31, 1979.

"In sick markets, mutual funds will be sick," said John Bogle, founder and senior chairman of the Vanguard Group of Valley Forge, Pa. "The industry looks bulletproof but believe me, no industry is bulletproof."

Industry executives interviewed for this story cited numerous reasons for the success of mutual funds - effective regulation, innovative shareholder services, creative marketing, investor demographics and the advent of personal retirement savings.

But the factor most commonly mentioned for the current prosperity in the mutual fund industry was 17 years of good to great financial returns. Market performance increased the assets mutual fund companies held and simultaneously attracted new investors, executives said.

"You can't underestimate the power of the bull market," said Roger Servison, executive vice president at Fidelity Investments of Boston.

Retirement plans become a

distribution channel

Thirty-nine years after it first provided for publicly-financed Social Security payments for retirees, Congress began privatizing retirement in the 1970s.

When it enacted the Employee Retirement Income Security Act, or ERISA, in 1974 and the Tax Reform Act of 1978, Congress effectively created a new mutual fund distribution channel - retirement plans. Those two laws permitted the creation of individual retirement accounts and 401(k) plans, dramatically expanding a market that up to that time had been limited to private retirement plans for the self-employed. (The ICI did not track that segment until 1981 because of its comparatively insignificant size).

The legislation may have been the best thing that happened to the mutual fund industry since Massachusetts Investors Trust. Fund sales to retirement plan participants accounted for $104 billion, or about 31 percent, of the $332 billion of net long-term fund sales in 1997, according to the ICI's annual report released last month.

The 401(k), the IRA and other tax-deferred retirement investment plans now constitute slightly more than one-third of the mutual fund industry's assets under management, the ICI said in its annual report. Assets in 401(k) plans accounted for $444 billion of the total $1.6 trillion in mutual fund assets in retirement plans.

"I knew it was going to be big, but certainly I didn't forecast it would be to the stage it is now," said Ted Benna, a benefits consultant in Balfont, Pa. who helped structure the first 401(k) plan approved by the Internal Revenue Service.

Fund companies jockey to obtain the most exposure possible in company retirement plans because of the plans' predictable cash flows and their captive audience of employees. There also appears to be a spillover benefit for mutual funds outside of retirement plans caused by uncertainty in the Social Security system Congress created in 1935. Much of the mutual fund investing done outside of retirement plans is driven by concerns about retirement, according to some mutual fund executives.

"It's all retirement savings," said William Shiebler, senior managing director of Putnam Investments of Boston. "That is the business. Americans realize that Social Security and their company pensions are not necessarily going to provide them with financial security."

Mutual fund executives hope Congress will increase the maximum annual 401(k) contribution to $15,000 from the current level of about $10,000. The industry also stands to benefit if a portion of the Social Security trust fund is invested in the stock market, a point several executives cited when contemplating the sales of mutual funds or products like mutual funds in the future.

But the importance of the retirement market to mutual funds has a downside. The population of individuals ages 40 to 60, a group Goldman Sachs called "prime savers," will peak at about 36 percent of the adult population in 2006, according to the U.S. Census Bureau. These baby boomers will then become what Goldman Sachs called "dissavers" and begin cashing out their retirement stakes.

"You'll have lower flows coming into the business and higher flows going out," said Shiebler.

Marketing gains importance

"One of the more widely-believed aphorisms on Wall Street is that mutual fund shares are sold, not bought," MFS said in its 50-year history of Massachusetts Investors Trust.

Marketing has become big business in the mutual fund industry. Mutual fund companies spent an estimated $469 million on advertising in 1998, according to Competitrack of New York, an advertising tracking firm. That total, which includes variable annuity and brokerage advertising, is up from $183 million in 1992, the earliest year for which Competitrack keeps comparable statistics.

The advertising figures do not account for the millions spent on marketing and seminars for intermediaries serving funds and investor education.

"That's what this industry is all about; it's about marketing," said Bogle.

From 1972 through 1981, a series of regulatory changes made it easier for funds to market themselves. Securities laws historically had limited how much a fund company could put in writing about itself and its funds' performance. The SEC made four changes in the rules which governed advertising in the 1970s. Collectively, the new and revised rules made it easier for funds to advertise generally and to advertise their performance in particular, the SEC said in a 1992 report. The SEC said it had been under "increasing pressure" to permit performance advertising.

The changes in advertising rules, the adoption of Rule 12b-1 in 1980 and the proliferation of the personal financial press all helped funds and fund companies market themselves, said Lipper.

"What we've seen is the ability of the fund business to raise its visibility and increase its number of selling points very dramatically," Lipper said.

The broadening of advertising rules occurred at about the same time fund ranking and rating firms started to appear. Lipper founded his own firm in 1973. Morningstar opened for business in 1984 and introduced star ratings in 1987. Mutual fund and marketing executives cited the combination of the more liberal SEC advertising standards, the rise of third-party ranking and rating firms and generally good market returns as factors which enabled the fund industry to expand its marketing.

Third-party ranking and rating systems are "the Consumer Reports to the mutual fund industry," said Servison of Fidelity. "They've become a way to sort out good funds."

Mutual fund marketing has provided benefits to investors. Marketing can attract assets to a fund, reducing expenses. In addition, marketing in the form of consumer education and improved communications helps explain how mutual funds work. SEC Chairman Arthur Levitt in a 1997 speech praised several companies for their efforts to improve communications, saying such steps lead to better understanding by investors.

Nevertheless, some other styles of marketing have drawn criticism. Barbash, in a 1997 speech to fund industry lawyers, warned that mutual fund marketing had spawned a "performance cult" which increased the chance that investors would abandon mutual funds when market performance deteriorated.

Another aspect of mutual fund marketing that is troubling is the fact that in the past 10 to 15 years, mutual fund companies increasingly have sold their funds as products, said Tamar Frankel, a law professor at Boston University and the author of a four-volume treatise on mutual fund law. Selling funds as products fosters a "buyer beware" mentality more suitable for tangible products, "whose performance is immediately apparent" than it is for an ongoing relationship of trust between a money manager and an investor, Frankel said.

Product advertising "is good for shoes," she said. "It's not good for the types of relationships we have developed in the entire financial system. Don't tell me that you are selling me a product. You should do things for me."

Regulation and the absence of


Mutual fund executives say that the starting point for the mutual fund industry's success is its clean reputation. That reputation is crucial to the growth of an industry which sells an uninsured, intangible product, executives and industry observers said.

"The companies themselves realize that reputation is everything," said Carey, the Pioneer Fund portfolio manager.

Executives attribute the absence of scandal to luck, the quality of people in the mutual fund industry and the Investment Company Act of 1940, the key federal law which governs mutual funds. Prior to the passage of that law, the mutual fund and closed-end fund industry's growth "came, in large measure, at the expense of the investing public," the SEC said in a 1992 report on mutual funds.

Frankel said the practices of money managers in the 1920s and 1930s combined with the Depression drove investors away from funds.

"The way to get them back was to establish trust in the system again," Frankel said.

Congress did that by establishing a standardized organizational structure for mutual funds in passing the Investment Company Act. The law also defined prohibited practices designed to disclose and mitigate the conflicts of interest between a mutual fund and the advisory firm that provides the money management skills on which the fund depends. Congress also imposed a duty of loyalty on the fund advisory firm to the funds it manages.

The Investment Company Act "attempted to take out all risks other than market risks," said Matthew Fink, president of the ICI. "It took out management risk."

Growth in the industry has created some uneasiness among fund executives about the ability to remain scandal-free, however. When the mutual fund industry was smaller - "the "backwater" Carey's lawyer friend alluded to in 1979 - it was easy for firms to see the benefit for all in following minimum standards, executives said. There also was less scrutiny from the press and government, executives said.

When asked about future threats to the industry, executives repeatedly cited the importance of maintaining a clean reputation.

"The fund business has been particularly blessed by having a minimum amount of scandal and fraud," said Putnam's Shiebler. "That doesn't guarantee that we have that (experience) going forward."

Attrition, technology key factors in future

The number of mutual funds is going to shrink and technology and the Internet will change the industry. Those are the two common predictions which mutual fund executives make about the future.

Both the number of mutual funds and the number of independent mutual fund companies will decrease, executives said. Although small new firms always will spring up, executives generally anticipate more consolidation, either in the form of outright purchases or semi-autonomous affiliations between money managers and large financial services firms. The attrition will be particularly keen if market performance becomes unfavorable, executives said.

"I think the marginal people will be badly hurt," said Bogle.

Technology may contribute to price competition and, for companies with scale, reduce expenses, executives said. Technology also may enable new competitors to enter the mutual fund industry by building on their existing ability to sell other products or services, executives said.

"I do believe there are other businesses trying to capture the household," said Donald Putnam, CEO of Putnam, Lovell, de Guardiola & Thornton. "I would watch out for Microsoft in the long run."

Whatever path it takes, executives believe that the industry has shown its ability to adapt, a skill they believe will carry it forward. The mutual fund industry has seen a depression, wars and recessions, said Fink. Despite those events, "the industry pretty much seems to go along," he said. "It's very flexible, very responsive to the market."

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