PHOENIX - Mutual fund fees and expenses are too high, their trustees are asleep at the switch, competition from alternative investments is bearing down, and the money management industry, by and large, has failed the everyday investor.

A starkly pessimistic assessment to be sure, admitted Investment Company Institute Chief Economist Brian Reid. But it's one that exists in many circles, and at the Investment Company Intstitute's 2006 Mutual Funds and Investment Management Conference last week, that argument served as the basis for a lively discussion on the health of the industry.

In the industry's defense, Reid offered a few telling statistics. Last year alone, registered investment company assets rose by $1 trillion, and inflows into mutual funds were $250 billion. Exchange-traded funds assets reached $300 billion, and closed-end funds increased for the fourth straight year to reach a record $276 billion.

It would seem to indicate that the industry is, in fact, satisfying investor demands, Reid said. But at the same time, panelist Tim Armour offered, fees and expenses overall appear persistently high, and there's a dearth of new product development.

"My opinion of the state of the mutual fund marketplace today is one of cautious optimism," said Armour, a managing director with Morningstar in Chicago. "There are reasons to be encouraged."

Crosscurrents, however, exist, Armour added. For instance, mutual fund expenses ratios are generally rising on an overall basis. Over the last 15 years, Morningstar research reveals, industrywide assets have increased by 10-fold, while expense ratios have also increased by 10-fold. At the same time, however, expense ratios in Europe are twice what they are here in the U.S.

"This is the best, most well-lit, lowest-cost playing field globally," he noted.

Competition seems a cause for concern, too. ETFs, separately managed accounts, hedge funds and hedge funds-of-funds are each growing much more quickly than mutual funds. But Armour cautions traditional fund complexes against pursuing a foothold in alternative investments. Looking at the SMA market, for example, the average earnings for the manager of a growth fund is about 38 to 40 basis points, which is tremendously lower than that of a registered, open-end mutual fund.

"A lot of money managers are looking at those markets, and they feel they cannot afford not to be in there because they are growing so rapidly. They feel they want to capture some of that growth," Armour said. "But if you track the amount of stocks in mutual funds and then track what's in some of these [alternative investments], it's dramatic how much smaller they are, and they're just not growing fast enough to ever overtake mutual funds in importance."

Avi Nachmany, executive vice president and director of research for the New York consulting firm Strategic Insight, recently examined the impact of alternative investments on the traditional fund industry and concluded that although they are increasingly popular, their attraction is complementary in nature.

Nachmany's research estimates that anywhere between $5 billion and $10 billion is cannibalized annually from mutual funds by SMAs, but SMA providers also reported significant increases in their old-line mutual fund business, as a result. ETFs have also emerged rapidly in recent years, grabbing about $50 billion annually, but Nachmany said it's interesting to examine exactly who's buying them.

"If you peel the onion, you will find that one-third of ETF investors are institutional in nature, and of the other two-thirds, 80% to 90% are financial advisers using the ETFs instead of stocks as short-term holdings," he said. "ETFs are not an alternative to mutual funds."

Overall, Nachmany thinks the state of the industry isn't terribly unlike three years ago when it was exiting the bear market and the war in Iraq was getting under way. He was optimistic then despite growing concern, and he remains optimistic today. For starters, the fund industry's assets, including ETFs, recently eclipsed the $10 trillion mark. There's another $10 trillion in fund assets under management outside the U.S., and that market is growing two times more rapidly.

Redemption numbers are also at record low rates.

"The actions of our clients tell us that everything is okay," he said.

Nachmany also credits the industry's intermediaries. One in five broker/dealers today are compensated at the point of sale, rather than through an ongoing fee setup. Their research teams are better, too, which means they're picking better funds.

"Clearly, the broker/dealers are organized to provide much better open-architecture, balanced, objective answers," he offered. "Investment management companies are also making better choices. Portfolio managers are making better choices. Turnover today is about one-third what it was four or five years ago. So, clearly, this industry is a good place to be."

But, returning to the topic of competition, Eric Sirri, professor of finance and the Walter H. Carpenter Chair at Babson College in Wellesley, Mass., said that while ETFs, SMAs and hedge funds occupy a relatively small corner of the investment management industry, they underscore the mutual fund industry's weakness in creating new products.

For example, Sirri distinguishes a great need in the market for a retail investment product that, like a 529 plan, would not just allow an investor to save for their child's education, but one that would hedge against the risk of skyrocketing college tuition costs.

"A legitimate question is, Are funds in the end a vehicle to solve these basic savings needs that people have?'" Sirri observed. "I never thought there was enough new product development in the fund industry.

"So, one of the great benefits of ETFs and SMAs to investors might not be their price competition, but their product development competition in pushing funds to think differently," he said.

Armour agrees that there's been a dearth of innovative new products in recent years, but he thinks the industry is on the brink of a product revolution, driven by the needs of the nation's 79 million Baby Boomers. He said Morningstar is currently providing retirement product development assistance to about a dozen clients, including several insurance companies, and that each want to include a significant mutual fund component in the new products. They're looking for a retirement solution that would, for instance, combine a fixed or immediate annuity with a diversified mutual fund portfolio, or a vehicle that would protect a retiree's savings from inflation and still deliver 4% to 5% income annually.

"If you think the party is over in mutual funds, you couldn't be more wrong," he said. "Those kinds of products are going to be a real growth mechanism for the industry."

Regulation and compliance, meanwhile, continues to draw the attention of funds boards away from more business-centric decision-making, the panelists said.

Laura Starks, chairman of the department of finance at the University of Texas in Austin, serves as an independent director for USAA Mutual Funds and on the investment advisory committee for the employee retirement system of the state of Texas. She thinks directors carry more influence than ever today. But they're also putting in more hours.

"We spend a lot more time on regulation and compliance. We certainly get a lot more information, and the meetings are much longer," she remarked.

The panelists suggested that the time might have arrived when fund board members need a small staff to glean through all the reams of information they receive, while complex fund data should be translated in user-friendly analytics before it hits their desks.

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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