Mutual funds are facing their greatest challenges in their existence. Can they remain the dominant investment of choice?

When Walter L. Morgan died in 1998, he had just celebrated his 100th birthday. However, he had left a corporate legacy far greater than just his extreme longevity: In the 1920s, Morgan raised $100,000 to launch an early mutual fund, the Industrial and Power Securities Co. - later renamed the Wellington Fund, in honor of a military hero of his.

In 1951, Morgan hired a young man who had just graduated from his alma mater, Princeton, named John Bogle. Under Bogle's eventual direction, the Wellington Fund became the flagship of what grew into the Vanguard Group.

With Morgan and Bogle, both fund and family prospered through wars and depressions - the Wellington Fund alone has more than $20 billion in assets. Morgan continued to come to the office twice a week well into his 90's. More than a pioneer, by his durability he became a symbol of an industry that has grown, changed and endured.

The question now is whether Morgan will continue to be a symbol for the industry or a vaguely remembered icon of its golden age.

Mutual funds are still the major investment vehicle, but could that change in the 21st century, especially with separately managed accounts at their heels?

Gary Gensler, undersecretary of the Treasury in the Clinton Administration, says the fund industry is out of touch with the investing public.

With an average turnover of 76% a year, "mutual funds need to go back to the basics of buy-and-hold," Gensler said. Costs are another matter - and turning to regulators for a political solution or forcing funds to share their proxies is not going to fix the problem.

The real problem, as Gensler sees it, is that the public is beginning to realize that even as they lose their investments, fund managers make a great deal of money. It's not an image the industry wants - but one that Gensler thinks the industry could shake by permitting truly rigorous fund governance, starting with the directors and fees.

Fund fees and portfolio trading costs have not escaped the attention of Michael Oxley (R-Ohio), chairman of the House Financial Services Committee, either. Even for the savviest investors, they are opaque, Oxley says.

Some believe the investing public is going to wake up - and shake up the industry. Roy Weitz, the Los Angeles-based CPA who publishes the offbeat mutual fund rating site www.fundalarm.com, thinks the industry will wind up consisting of big families at one end and small boutiques at the other.

Like many others, Weitz believes fund companies that move to adviser-sold funds will survive. "And there will be a continued interest in B shares, with investors holding them until the load disappears," Weitz said.

Gensler agrees with Weitz on consolidation. "You won't see 8,000 funds in 10 years," he said. "American business organizes itself into phases, and now we're in a decade of consolidation." In the near term, small funds may close. Those with $50 million to $100 million in assets will find they aren't even breaking even.

But not everyone sees such a "barbell" effect. Investment Company Institute research, noted President Matthew Fink, shows that the big guys are not taking over: The top five mutual fund complexes held 37% of total mutual fund assets in 1990, as opposed to 33% in 2001. The top 25 saw a decline from 76% to 73% in the same period.

Still, Weitz and Fink can agree that at least for now, nothing is posing a dangerous challenge to the $6.3 trillion mutual fund industry.

Strength in Face of Disaster

The fact remains that the mutual fund industry has held up resoundingly well during this grueling bear market. The industry's assets are down only 14% in from their $7.3 trillion March 2000 high, whereas the S&P 500 has tumbled 37% in the time since (see MFMN 4/14/03). Other investments that pose the greatest threat are a mere drop in the trillion-dollar bucket. Separately managed accounts are just under $400 billion, and hedge funds can boast $650 billion.

Long associated with the wealthy, separately managed accounts have a psychological advantage - like carrying around a gold American Express card, even if you have no use for its expensive features.

But "they have a long way to go," said Weitz, who cites mutual fund advantages while listing SMA drawbacks. "Do SMAs have full transparency? Do they have standards? These actually may be a big step backward. Mutual funds say where you stand." And while acknowledging the growth of SMAs, Fink said the ICI believes that most of their growth comes at the expense of individual securities, not from mutual funds.

"We're all fascinated by the latest product," he said. "But we're the ones with the tough regulatory system."

Don Holborn, executive vice president of Fidelity Investments Institutional Services Co., is also unconcerned about SMAs. (With about $755.4 billion in mutual fund assets, the firm can afford to be unconcerned.)

"We believe that mutual funds can be a natural complement to other investments. We're still a core holding," Holborn said.

"The mutual fund is the most efficient way to gain access to high-end money management, to mitigate risk and to gain asset allocation," he said.

Smart Fund Shopper

Daniel Galli, a CFP and independent rep, in Rockland, Mass., who advises extensively on 401(k) and 403(b) accounts, finds himself in agreement with Holborn: "Mutual funds are the ideal way for my clients to participate in the equity market." That's not to say he's completely happy.

"I think fees are a considerable factor," he said, adding that he doesn't like the way they continue to rise. A shakeout is needed, he said. Perhaps, he suggested, there just may be too many funds out there. "It's mind boggling." However, he has managed to find funds with reasonable fees, a task he says that is a valuable service for him to perform for his clients.

Turnover is also important. "You have to know before you go. But if a fund really works with high turnover, I can live with it. Still, I'd really want to know why they're scrambling so much," Galli said.

But he's not turning away from the product, and industry claims notwithstanding, he isn't moving to SMAs anytime soon. "The vast majority of my clients can't meet those minimums."

Another independent rep, Robert FitzSimmons, CFP, in Lincoln, Neb., has 95% of his clients in mutual funds. "There haven't been too many scandals, and I stick with the top fund families." He also prefers larger funds because he finds them less expensive, and uses Morningstar to track costs. "I look at each client to choose the right share classes and figure out the breakpoints." He also checks the turnover - again, he finds high-turnover funds tend to be the most expensive.

FitzSimmons' concern over fees is what led him to ultimately reject the idea of SMAs: "Now those are high fees! And their performance usually doesn't impress me. I need to do something different or I'll lose my clients." Of course, there's always a different mutual fund around the corner.

And this takes us back to Bogle, as obsessed with costs as any planner.

True to the heritage of Vanguard, and of the mutual fund industry himself, he lashed out at rising fees in recent Congressional testimony.

"A study of stock fund returns during the decade ended June 30, 2001, for example, showed that the low-cost quartile of funds earned an average net return of 14.5% per year, while the average high-cost fund earned an average of 12.3%," Bogle testified in Congress. The more you pay, the less you get, Bogle told Congress.

As a result, he doesn't share the ICI's blithe view of the industry's happy state. "In my considered judgment, the fund industry has moved from what was largely a business of stewardship to a business of salesmanship, a shifting of our primary focus from the management of the assets investors have entrusted to our care to the marketing of our wares so as to build the asset base we manage," he said in an interview.

Still, no critic can dismiss mutual funds entirely. Or even partially. Gensler, who lauds index funds because they marry good performance to low costs, notes that "there is a tremendous amount mutual funds can do."

And Bogle, after 54 pages of bitter criticism, managed to conclude his testimony on a high note: "If funds come yet again to focus above all on serving our shareholder - serving them in the most efficient, honest and economical way possible - the future for this industry will be not just bright, but brilliant."

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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