William M. Lyons, president and chief operating officer of American Century Companies of Kansas City, Mo., is the chairman of this year's general membership meeting of the Investment Company Institute. Lyons discussed the state of the mutual fund industry with Mutual Fund Market News reporter Mike Garrity. An edited account follows.
MFMN: Do you expect that a majority of fund distribution in the future will come through some sort of intermediary?
Lyons: There is no doubt that in the last three to five years, we've seen a big shift in distribution patterns moving from direct distribution to intermediaries, particularly through fund supermarkets like Schwab. But I think the future of distribution at this point is unknown. The largest single factor that is impossible to assess right now is the Internet.
The Internet is a tool that could greatly enhance direct distribution and has the potential of returning some of the asset gathering power to that channel. I don't think mutual funds have effectively used the Internet to promote their direct distribution.
Compare funds to what's happened in the online brokerage industry, for example. In that industry, the Internet has created tremendous asset growth because of the sophistication and convenience of some of the tools. In the mutual fund area, we have not yet seen a lot of investors using transactional capabilities through the Internet.
MFMN: Do you think the Internet will provide growth in market share for funds that are sold directly?
Lyons: I do, and I may be in the minority. I think that if mutual fund firms can provide the right electronic experience for their customers, it could reinvigorate direct channel asset gathering. We need to do a much better job of creating tools such as advice to gather assets to reinvigorate that channel.
The movement toward intermediaries in my view has been in large part about advice. I do not think the mutual fund industry at this point has created good enough advice tools and other services that surround the core investment management service. Once we do that and create the right experience, I do believe that we could see increasing flows in the direct channel.
MFMN: Are the demographics of the mutual fund investor different than that of the online brokerage investor?
Lyons: I think the difference in the demographics is real and I think the difference in psychographics is real. I think the demographic information would show on average a younger, probably more aggressive investor, one that's more oriented toward aggressive equity investing. It's certainly an investor profile that would suggest shorter holding times for investments and more frequent trading.
Mutual funds have not tried to build their services specifically for that demographic or psychographic. It is very disturbing for the mutual fund industry that average holding periods have dropped from 10 or 11 years, looking back a decade, to now something around two years or less. That kind of change in behavior would not be at all a concern to the online brokerage community. Most mutual fund companies have not built electronic environments that promote frequent trading or short holding periods. In fact, it's just the opposite.
There is something different about the electronic medium because it is so immediate. It fits better with the online investor psychographic. There is immediate feedback to doing a trade online, immediate gratification. You can see it. Investing in our Ultra Fund with the expectation of staying there for years doesn't have quite as much thrill.
MFMN: Does the shrinking mutual fund holding period run the risk of making mutual funds irrelevant or diminishing their popularity?
Lyons: I don't think we know the answer to that. I do think what we're seeing now in terms of holding periods may be a product of the unique environment we've been in. If we get into a period of less favorable performance or a bear market, I think we could see enormous shifts in the opposite direction in terms of holding periods.
I don't believe that we have permanently shortened average holding periods. I have every expectation that holding periods could change as market conditions change, as they have in just the last couple of weeks.
MFMN: Fund sales were down last year from 1998. Do you attribute that to a maturing of the industry, new competition or other factors?
Lyons: The demographics would suggest that it's not simply a maturing of the industry. We're right in the middle of the baby boomer generation at its peak savings and investing years. I don't think that demographic is going to change for a good number of years. It's more of a product shift, in my view.
Even though mutual fund flows have been positive and overall quite healthy, it seems clear to me that the online brokerage business has taken assets away from direct mutual fund holding. The rate of growth of online brokerage is dramatically higher than the rate of growth of direct mutual fund investing.
MFMN: Do you think that is a result of market performance in recent years?
Lyons: I do. The proof will be in investor behavior in a down market. Will investors gravitate back toward a professionally managed, diversified, less risky mutual fund? I think the answer to that is yes.
MFMN: Last year there was a concentration of sales among large firms. Why, and are there any particular implications for the industry?
Lyons: It's a performance issue, particularly in the case of top performing groups like Janus. But it's also an Internet and availability of information issue. I think the Internet is extraordinarily good at sorting information into bite-sized chunks. As a result, you're getting an awful lot of people who are getting their information online who are just getting focused on the very top performing funds. It's harder for a fund in the middle of the pack to get any attention, particularly through the electronic channel.
MFMN: That's because many funds are getting lost in the vastness of the Internet?
Lyons: And the vastness of the industry. We have an excess of funds right now. I would not be surprised to see some significant consolidation in the number of funds, not necessarily the number of fund providers. I think fund producers will have to rationalize their product lines in the coming years if the middle of the road performers continue not to attract new assets.
MFMN: Recent annual reports suggest fund companies are changing from fund companies to diversified money management firms. Have you seen that?
Lyons: I'm probably not a good person to answer that question because our business here is extraordinarily focused on mutual funds. It is interesting to me that American Century is just now in the early stages of beginning an institutional money management business. So perhaps your observation is correct if you look at the example I know best, which is our company.
We at American Century are broadening what we do beyond mutual funds because we think there are more opportunities to do institutional or separate-account management, particularly outside the U.S.
MFMN: You haven't had much presence in that area previously?
Lyons: Very little. Well over 90 percent of our assets historically have been in mutual funds. At times as high as 99 percent of our assets have been in mutual funds.
I believe we are at the very low end in terms of our separate account presence. Most other companies that we consider competitors have a much bigger institutional or separate account business in terms of assets. I think it will be a natural thing for companies to do if there is a concern that the mutual fund vehicle has matured. I want to be very clear that I do not think that's the case.
MFMN: How significant do you see the competitive threat from exchange-traded funds and other alternatives over the next three to five years?
Lyons: Right now it doesn't look like it is a material threat. There are lots of interesting ideas about what could be done to approximate a mutual fund vehicle using electronic tools where the customer would have direct holdings in underlying securities. The advantage of doing that would be control of tax consequences. I think that's real to the customer. But in the end, I believe that what will be most important to the customer is investment results.
My feeling is that full-time professional management will win out over individual customers who may have control but are not experts and are not able to devote as much time and attention to the process.
MFMN: When you say professional management, do you mean both active management and index management?
Lyons: I think the biggest threat posed by using electronic tools to invest directly in a broadly diversified pool of securities is to index managers. I think there is a potential to recreate indexes efficiently with fewer tax consequences using electronic tools.
Next in line in terms of threat would be more quantitatively- managed equity products - not indexes, but those products that use quantitative tools that are well defined and could be obtained on the Internet, for example.
I think true active managers are the ones who have the most defensible position against any threat of the type you're talking about.
It's not a simple answer. I think certain parts of the mutual fund industry are potentially more at risk than others. Those that have the most defensible position are the true active managers, because it is hardest to recreate that. It's the least like a commodity. It's judgment. It's art. You can't prepackage it and put it out in a product that's available electronically for the world.
MFMN: What areas of growth do you see for fund companies?
Lyons: We are going to be focused on electronic distribution because we are just scratching the surface there.
The other area that's closely related is providing electronic advice. I think there are huge opportunities in advice. Not only investment advice but going beyond that to more holistic financial services.
The other opportunity clearly would be international, which has been a puzzle for our industry for the last 20 years. But there does seem to be more movement and more openness now than we have ever seen. There are opportunities for U.S.-based fund managers to introduce their products into non-U.S. distribution networks.
MFMN: Is there any broad issue that you see facing the industry?
Lyons: We've all been struggling with why certain parts of the financial services industry have customers who have embraced the Internet fully while mutual fund customers seem a bit more reticent.
The big issue in my mind is how to create that compelling electronic experience for a customer. The channel mix questions are important, but I just don't think we know the end of the story yet. I'm not at all ready to give up on the Internet as a way of returning asset flows to the direct relationship.