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Mutual Funds Well-Equipped for Accelerated Growth

The bullish case for the asset management business is stronger than ever, as long-term mutual fund assets have risen over $600 billion in the first half of 2003.

Bolstered by a giant stock market rally in recent months, the U.S. mutual fund industry has clawed its way back to $7.3 trillion in assets, nearly matching its all-time high set back in early 2000, according to Strategic Insight. That could potentially mean extraordinary growth for asset managers over the next few years, the New York-based research firm said in a report.

"If investment confidence remains stable during the second half, the mutual fund industry would experience even faster growth in coming months, making 2003 one of the best expansion years for the industry," said Avi Nachmany, Strategic Insight's director of research. "Clearly, mutual fund demand today, after three challenging years, demonstrates that individual investor confidence has rebounded quicker than that of the business economy," he said.

Mutual funds have weathered "a perfect storm" within the financial industry by posting sound sales numbers and maintaining stable retention patterns during turbulent times. In fact, two-thirds of stock and bond fund managers attracted positive cash inflows during 2002, with 2003 shaping up to show similar ratios, the report indicated. In fact, new sales of stock and bond mutual funds last year still managed to top any year during the bull run of the '90s, Strategic Insight said.

On the fixed-income side, bond funds reversed their outflows from 2000 by bringing in $94 billion in 2001. That streak continued to grow legs over the next 18 months as they recorded an additional $161 billion last year and $85 billion in the first half of 2003.

The nation's fund investors, comprised of half of all American households and owning roughly 300 million fund accounts, have shown greater confidence in mutual funds than most insiders during a very fragile time psychologically for the markets. Strategic Insight believes that if improving market sentiment continues to fuel buying trends, cash inflows to actively managed stock and bond funds will exceed $200 billion this year. That would put cash flow results very close to their 2000 high volume mark.

Driving that demand for funds in recent months has been the call for fixed-income exposure, heightened diversification, steady retirement flows and investors' growing preference of mutual funds over individual stocks. In the long run, the report indicated, sustained demand has been made possible by the two-thirds of equity fund assets that reside in retirement accounts, coupled with a steep yield curve. Essentially, retirement will not go away no matter whatever the economic landscape.

In terms of retention of previously purchased assets, the environment has been relatively stable for the most part. After weeding out time zone arbitrage trading and various other market-timing strategies, fund investors show "amazing stickiness," the report said.

Another key finding was that a large number of redemptions can be attributed to a very small portion of shareholders. Only 5% of shareholders trade four or more times in a given year, according to a study conducted by the Investment Company Institute in Washington. Three-quarters of shareholders make no trades. The bottom line is that a handful of active traders, mostly institutional, inflate the average redemption rates, while an overriding majority subscribes to a buy-and-hold investment strategy.

Also at issue is the hype surrounding alternative investments such as separately managed accounts, exchange-traded funds and hedge funds. Strategic Insight believes that these investment products are not living up to their promises and that they are not stealing any real market share from mutual funds, calling for a reality check in the asset management business. For example, the firm said that SMAs have "cannibalized" less than $4.6 billion from mutual funds, representing a mere 0.1% of total mutual fund assets. It also argued that SMA growth has come to a halt in the last 12 months as the product's "exaggerated promises have become more transparent."

Supporting Growth

The industry's prospects for accelerated growth are supported by a number of factors outlined in the report. First, recent tax laws imposed by the Bush administration have made mutual fund investments more attractive. Second, increasing retirement investments by individuals and pension allocation by companies represent two positive trends for the business. Another significant trend supporting future growth is the continuing shift toward managed assets from individual stocks.

Lastly, and perhaps most importantly, is the rejuvenation of investors' psyche. "As investor confidence rebounds, following the recent global stock market recovery, once again households will accelerate their net selling of direct stock holdings, while equity fund net buying [will] rise again," the report said.

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