Jeffrey Lyons, senior vice president of mutual funds for Charles Schwab & Co., of San Francisco, recently spoke to Mutual Fund Market News reporter Mike Garrity about trends in fund distribution and product development. Lyons is one of the speakers on those topics at the Investment Company Institute's Tax & Accounting Conference beginning today in San Diego, Calif. An edited account of their conversation follows.

MFMN: How do you think fund distribution will change in the next three years?

Lyons: I think there are a number of things that are happening in terms of mutual fund distribution. One is there seems to be this blurring between load and no-load. You see the various wirehouses creating asset-based programs where they're including more and more no-load fund companies. You hear a lot of things about fund companies considering whether they want to go from no-load to load. You have the load companies who are creating more classes of shares to compete in various distribution channels and creating shares that can be bought at NAV. I think you'll continue to see that.

I think overall too, we're already seeing a slowing of new fund development. You're seeing more and more this year funds merging or closing because it is a tough competitive environment.

MFMN: Do you think the number of fund companies will decrease because of competition?

Lyons: I don't think so. Certainly you see a lot of banks or insurance companies buying asset management firms but there doesn't seem to be a lot of fund companies actually going away. They may be part of a different corporate structure.

With things like supermarkets and companies being able to be niche players, I think you'll constantly see portfolio managers breaking away and creating their own firms.

I would also say that from a fund distribution standpoint, the Internet is going to change things. You've already seen fund companies creating shares that are electronic-only. They're using the Internet and e-mail more creatively to communicate with their shareholders or promote themselves. I think that will continue to have an impact over the coming years.

MFMN: Will the growing use of the Internet cause a change in distribution, products or pricing?

Lyons: I think you'll see products priced specifically for different kinds of channels. Does that mean products distributed for other channels are going to go down? I don't think that necessarily is going to be the impact. But I do see that there will be more creative ways for fund companies to communicate with their shareholders. I think you're going to see more and more firms looking at ways to eliminate paper, which can help reduce expenses, and then pass that reduction on to more cost-effective products or to investors.

MFMN: Will everyone sell their products in every channel, load and no-load, with advice becoming the way firms differentiate the way they price their products?

Lyons: I'm not sure that a lot of the fund companies are going to be omnipresent in all different channels. A lot of load fund companies are going to continue to have channel conflict issues where it is just not feasible for them to go no-load in supermarkets or over the Internet. I think a lot of those companies are going to continue to look at the full commission broker network as their primary mode of distribution.

MFMN: Invesco announced recently that it soon would make it possible for shareholders to open accounts online. Is that a significant event?

Lyons: I think, overall, more and more firms are going to offer their customers easy access either to open their accounts or add money to their accounts. I think that's a beginning of a trend. Certainly you can do that at Schwab and some other broker/dealers. I think you will see more and more fund companies understanding the need to respond to customer demand to do more and more things over the Web.

At Schwab, in just our mutual fund business, we're doing about half of our transactions electronically.

MFMN: Is that a plateau or will Internet use for fund purchases continue to grow?

Lyons: It's going to continue to increase. The trend is continuing.

MFMN: Are new products such as separate accounts and exchange-traded index funds going to become prominent or is the mutual fund here to stay as the investment product of choice?

Lyons: I think for most investors, mutual funds will continue to be the vehicle of choice. Although net flows are down from the heights back in 1997, people are continuing to buy mutual funds. It's a great mechanism for people to get diversification and professional management.

Many investors will continue to see (separate accounts) as a way to go to make sure that they can tax manage their portfolios in a way that's very difficult to do with mutual funds. On the issue of exchange-traded products, I think you will see the increased desirability of some of those products, particularly among investors who want to attempt to time the market. Those are products that are probably better suited for those kinds of investors.

MFMN: What do you see with respect to fund investors taking some of their proceeds and buying securities directly?

Lyons: We certainly see a greater share of our customer's wallet is moving into direct investments like stocks. That said, we don't see much evidence that people are wholesale liquidating their mutual funds in order to do that.

Certainly a lot of the newer investors are going into individual equities. For the majority of investors, mutual funds will continue to be the vehicle of choice.

MFMN: Are you seeing increased migration toward index funds among the fund choices on OneSource?

Lyons: If you look at our net flows, we're seeing a higher and higher percentage of those net flows going into index funds. That said, it still represents a relatively small proportion of the total assets, either in the industry or at Schwab. But when you look at just the net numbers, a big proportion is going into index funds.

Part of it is that we see this constant flow of assets going into index funds without much going out. In some ways that distorts the number. If you looked at the percentage of gross sales going into active versus index, index is still a very small proportion of gross sales.

MFMN: Schwab continues to build its Internet presence at the same time that it continues to open new branch offices. Do you see that dual strategy continuing or eventually will the brick and mortar part of Schwab erode?

Lyons: We really see opportunity in the integration of the physical and electronic world. It's not really an issue of bricks and mortar versus the Internet. It's pulling the best of both together.

Investors continue to want to have that physical presence - or at least a good percentage of our investors continue to want to have that physical presence. Our overall strategy is building a company with clicks and mortar, (with) people being able to access us the way they want, how they want, at the time that they want, which we think is going to be the winning strategy.

MFMN: Do you see the changes in the industry now squeezing profitability of mutual fund companies?

Lyons: This is an extremely tough environment for fund management companies, especially given the kind of market where the rally has been extremely narrow. I think things are already changing in 1999 where active management has been able to beat passive strategies at a much higher percentage than it has over the last few years.

Obviously (fund companies) are getting competition from other kinds of products, with pricing on individual equities going down significantly, with information about investing just omnipresent on the Internet at no cost. People certainly have alternatives to mutual funds. It's a tougher competitive environment out there.

I think it is incumbent upon fund management companies to look at what their overall strategy is - their distribution strategy, what their firms stand for, how they communicate the value that they're bringing to investors.

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