Strong stock markets and the improving economy, along with new alternative investment products and the continuing appeal of ETFs, are boosting prospects for the sector. New funds are opening at a rapid pace. Expect more SEC scrutiny of mutual funds boards, but new regulations for money market funds are not on the immediate horizon. Hedge fund managers are also entering into the mutual fund sector by adding registered funds in order to access retail capital.

In 2013, on the back of buoyant stock prices, some $352 billion flowed into all stock mutual funds and ETFs, a new record. Much of the money for equities was put into index funds. Meanwhile, throughout the year, concerns about rising interest rates helped force outflows from bond funds for the seventh straight month.

With new managers getting into the business, 2013 saw funds opening at a very strong pace. The move of hedge fund managers into the mutual funds space bodes well for the industry, as does the growth of ETFs.

ETFs keep on commanding investor interest: Assets grew 25% in 2013 to $1.7 trillion. Two trends worth noting are: (1) Funds are being devoted to ever-slimmer niches of the investing universe, e.g., master limited partnerships and companies that avoid too-aggressive accounting, and (2) There's greater interest in actively managed ETFs, which have attracted additional mutual fund powerhouses, such as Fidelity.

ALTERNATIVE MUTUAL FUNDS

Alternative mutual funds continue to grow in popularity. In the face of such an extended period of low interest rates, 2013 was marked by a big chase for yield. We're seeing a notable move to alternative investment strategies, like long/short, real estate and so forth. On the fixed-income side, we're seeing more high-yield approaches.

Unlike hedge funds, these alternative product funds are registered under the Investment Company Act of 1940 (1940 Act) and must comply with mutual fund regulations. These allow investors to withdraw cash overnight, offer lower minimum starting investments, make their fund holdings transparent to investors and include limitations on charging a performance fee. AUM for liquid alternative products were $279 billion at the end of the Q3 2013, compared to just $68 billion in 2008.

In addition, mutual fund and hedge fund managers are collaborating more closely, and more mutual fund assets are under the direction of hedge fund managers. A lot of that is being done through master series trusts, a turnkey mutual fund operation. Fund administrators establish a trust and register the trust with the SEC. The fund administrator will then hire the board, legal counselors, auditors, custodians, etc. The portfolio manager can then just drop its fund into this pre-existing trust, saving it all the work of performing the initial registration process and creating a back office, while generating large economies of scale.

The downside? Being a mutual fund increases the regulatory scrutiny that comes from being covered by the 1940 Act. But being able to increase your base to retail investors who are not accredited investors can be a net positive.

On the other hand, some hedge fund strategies don't fit well into the mutual fund model and its requirements, such as the need to have daily liquidity. So these strategies use interval funds, i.e., closed-end funds that allow redemptions only on a quarterly basis and only up to a certain percentage of the fund's total assets. The use of interval funds represents the continuing evolution of the mutual funds industry, and its adaptability in the face of changing investment conditions.

In the tax area, with more mutual fund investors in the black and considering redeeming shares, there's growing interest in so-called income equalization, an accounting technique that can limit year-end capital gains distributions and lead to higher year-end returns. The giant fund families have been using this technique for years; now is the right time for smaller funds to take note.

REGULATORY AND TAX ISSUES

Last year, in a seldom-seen effort to hold boards accountable, eight former directors of Morgan Keegan, the large Memphis-based investment firm, were accused of failing to properly oversee the activities of the firm's portfolio managers, which allowed them to overvalue mortgage assets prior to the financial crisis. Morgan Keegan paid $200 million to settle fraud charges. Although board members weren't fined, the SEC is sending a clear signal that they're taking a harder look at the board's role in overseeing valuations. The agency is planning to issue new rules regarding the valuation of investments in registered investment companies, but the timing remains murky.

Also in June, the SEC issued a proposal for the regulation of money market funds. The proposed guidance offered two alternatives that could be adopted alone or in combination. The first would require funds to value their portfolios every day based on a floating net asset value. Under the second alternative, MMFs would still be allowed to transact at a stable share price, but it would impose liquidity fees and gates (i.e., a temporary suspension of redemptions) in times of stress. In both cases, the rules would apply only to institutional funds (funds that are geared toward large, institutional investors); government and retail money market funds (funds that are sold to individual investors) would be exempted.

John Stomper is national mutual funds practice leader at Grant Thornton LLP.

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