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Long Workdays Lie Ahead for Funds: No. 1 Priority Should Be New Products, Experts Say

PHOENIX - Mutual fund fees and expenses are too high, their trustees are asleep at the switch, competition from alternative investments is bearing down, and the money management industry, by and large, has failed the everyday investor.

A starkly pessimistic assessment to be sure, admitted Investment Company Institute Chief Economist Brian Reid. But it's one that exists in many circles, and at the Investment Company Intstitute's 2006 Mutual Funds and Investment Management Conference last week, that argument served as the basis for a lively discussion on the health of the industry.

In the industry's defense, Reid offered a few telling statistics. Last year alone, registered investment company assets rose by $1 trillion, and inflows into mutual funds were $250 billion. Exchange-traded funds assets reached $300 billion, and closed-end funds increased for the fourth straight year to reach a record $276 billion.

It would seem to indicate that the industry is, in fact, satisfying investor demands, Reid said. But at the same time, panelist Tim Armour offered, fees and expenses overall appear persistently high, and there's a dearth of new product development.

"My opinion of the state of the mutual fund marketplace today is one of cautious optimism," said Armour, a managing director with Morningstar in Chicago. "There are reasons to be encouraged."

Crosscurrents, however, exist, Armour added. For instance, mutual fund expenses ratios are generally rising on an overall basis. Over the last 15 years, Morningstar research reveals, industrywide assets have increased by 10-fold, while expense ratios have also increased by 10-fold. At the same time, however, expense ratios in Europe are twice what they are here in the U.S.

"This is the best, most well-lit, lowest-cost playing field globally," he noted.

Competition seems a cause for concern, too. ETFs, separately managed accounts, hedge funds and hedge funds-of-funds are each growing much more quickly than mutual funds. But Armour cautions traditional fund complexes against pursuing a foothold in alternative investments. Looking at the SMA market, for example, the average earnings for the manager of a growth fund is about 38 to 40 basis points, which is tremendously lower than that of a registered, open-end mutual fund.

"A lot of money managers are looking at those markets, and they feel they cannot afford not to be in there because they are growing so rapidly. They feel they want to capture some of that growth," Armour said. "But if you track the amount of stocks in mutual funds and then track what's in some of these [alternative investments], it's dramatic how much smaller they are, and they're just not growing fast enough to ever overtake mutual funds in importance."

Avi Nachmany, executive vice president and director of research for the New York consulting firm Strategic Insight, recently examined the impact of alternative investments on the traditional fund industry and concluded that although they are increasingly popular, their attraction is complementary in nature.

Nachmany's research estimates that anywhere between $5 billion and $10 billion is cannibalized annually from mutual funds by SMAs, but SMA providers also reported significant increases in their old-line mutual fund business, as a result. ETFs have also emerged rapidly in recent years, grabbing about $50 billion annually, but Nachmany said it's interesting to examine exactly who's buying them.

"If you peel the onion, you will find that one-third of ETF investors are institutional in nature, and of the other two-thirds, 80% to 90% are financial advisers using the ETFs instead of stocks as short-term holdings," he said. "ETFs are not an alternative to mutual funds."

Overall, Nachmany thinks the state of the industry isn't terribly unlike three years ago when it was exiting the bear market and the war in Iraq was getting under way. He was optimistic then despite growing concern, and he remains optimistic today. For starters, the fund industry's assets, including ETFs, recently eclipsed the $10 trillion mark. There's another $10 trillion in fund assets under management outside the U.S., and that market is growing two times more rapidly.

Redemption numbers are also at record low rates.

"The actions of our clients tell us that everything is okay," he said.

Nachmany also credits the industry's intermediaries. One in five broker/dealers today are compensated at the point of sale, rather than through an ongoing fee setup. Their research teams are better, too, which means they're picking better funds.

"Clearly, the broker/dealers are organized to provide much better open-architecture, balanced, objective answers," he offered. "Investment management companies are also making better choices. Portfolio managers are making better choices. Turnover today is about one-third what it was four or five years ago. So, clearly, this industry is a good place to be."