As the 76 million Baby Boomers begin to retire in the next five years - creating the biggest demographic wave in our country's history - they will hunger for "outcome-oriented" funds that mitigate risk and either generate income, protect principal or guarantee at least modest returns.

With the assets of these retirees and near-retirees making up two-thirds of all assets by 2010, the mutual fund industry will have no other choice but to heed these new demands, competing with insurance companies and investment banks, which are already adept at providing such products.

This will prompt broker/dealers to begin to pay closer attention to performance, income generation and risk management than to neatly packaged products, fundamentally transforming what types of mutual funds are brought to market and how they are sold through third-party channels.

This is the conclusion of a report on "The Asset Management Industry in 2010" that McKinsey & Co. of New York has just issued, based on surveys and interviews with retail and institutional investors, top executives at mutual fund and alternatives firms, as well as key decision makers across all distribution channels.

"As much as 25% to 30% of leading firms' earnings will be derived from products they aren't even offering today," according to the report. Further, the time-honored tradition of assessing funds through the Morningstar style boxes and benchmarked, relative performance will be replaced by the increasing popularity of outcome-oriented funds that combine various investment styles to promise returns and investors' peace of mind.

"Consumers are now actively interested in purchasing financial products that will not only limit their exposure to market risk, but also to inflation, taxation, health care and other risks," according to the report. "This presents a distinct challenge to asset managers, as the business models of most are still firmly rooted in accumulation mode, with the primary focus on products, not customer needs."

While the retail mutual fund industry grapples with these challenges, similar dynamics will alter institutionally managed funds, as well. Worsening pension deficits and an uncertain market environment are changing the way defined benefit sponsors evaluate and pay for performance. They, too, are looking to minimize risk and are beginning to assess alpha and beta separately.

Be they retail or institutional investors, "consumer needs are changing fundamentally," according to McKinsey.

This, the firm predicts, will lead to other changes among asset management firms. In order to produce these products and remain profitable, "the need for scale will intensify, with the very largest players easily topping $2 trillion in assets." Investment banks and insurers will play a much more visible role in the investment management industry. Mergers and acquisitions will continue, although not as rapidly as in the past few years.

Probably one of the most surprising conclusions of the report is the break away from style categorization. Today, Morningstar classifies funds in 63 separate categories, up from 44 a decade ago. But building portfolios based on style has not served either asset managers or investors well, according to McKinsey's findings. Lipper data indicates that narrowly defined mutual funds have underperformed broadly defined, multi-cap funds over the past decade. In fact, the tremendous popularity of various styles has prompted fund companies to produce far too many products, causing a drag on profits, according to McKinsey.

The management consulting company believes "successful firms of the future will break away from the pack and offer fewer products that are also more broadly defined, cutting across current style categories," that is, outcome-oriented funds. Such funds would include annuities, principal-protected funds, lifestyle or lifecycle funds and tax-managed funds. While many of these products are still fairly new, according to McKinsey, they are already growing much faster than the mutual fund industry. Between 1994 and 2005, assets in outcome-oriented funds have grown 28% a year, versus an overall growth rate of 13% a year in the mutual fund industry.

Changes among broker/dealers will also significantly alter the mutual fund business. As the fee-based, wrapped model has increased among financial advisers and broker/dealers, many of them are packaging investment solutions at the home office. In addition, concerns over regulators' heightened scrutiny of suitability have also prompted many brokerages to move the selection of which funds to offer to headquarters.

Mutual funds that will succeed in making the cut, according to McKinsey, will be those that deliver strong performance; charge low, institutional-level fees; and are sold by wholesalers who take an institutional approach, helping advisers adapt their book to changing customer needs. They will also spend more on client service than other firms, segment the specific needs of various advisers and build sophisticated call centers.

"As distribution becomes more gatekeeper-centric, and traditional mutual funds become increasingly commoditized, winning asset managers will be those who [offer] superior service and sophisticated advice," according to McKinsey.

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

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