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Funds Flows on Track to Outpace 2005

The mutual fund industry has seen strong inflows thus far this year, and the market outlook appears stable for the rest of the year, pointing to a generally promising outlook for 2006, according to a report from Strategic Insight of New York.

Over the past six months, stock and bond long-term funds have netted $175 billion in inflows, according to the State of the Mutual Fund Industry Mid-Year 2006 report.

There has been a high level of investor confidence in mutual fund vehicles even during the difficult past few years, said Avi Nachmany, director of research at Strategic Insight. Worldwide mutual fund net inflows neared $1 trillion last year and more than $400 billion in the past six months.

At this pace, net flows into U.S. long-term funds by the end of this year could surpass the nearly $300 billion they took in during 2005, when they declined from the $325 billion they took in during 2004.

However, due to stock market declines since early May, year-to-date returns of U.S. diversified funds through July are only slightly positive. The continued decline in stock prices and geopolitical concerns have brought economic confidence down with them and have recently slowed inflows to mutual funds, the report noted. However, once investment confidence rebounds, so will inflows to mutual funds. The possible peak in the interest rate cycle in the U.S. should help global economies and counter some of the economic fallout from the Middle East crisis.

Notwithstanding the recent pause in investors purchases, we believe that optimism about wealth management through mutual funds persists worldwide, suggesting new growth opportunities for money management over time, according to the report.

New products have been emerging and active product development will continue. While exchange-traded funds have moved to the forefront, they are not directly competing with flows to mutual funds, according to Strategic Insight. A majority, over 80% by some estimates, of ETF purchases by advisers and individual investors are substitutions of stock and separately managed accountsnot a replacement of buy-and-hold mutual funds.

Strategic Insight also said there has been a noticeable shift in investors creating more prudent asset allocation and increased diversification. Investors are increasingly gravitating to U.S. growth funds and shying away from value-orientated funds, which have dominated investment choices over the past four years. Additionally, there has been an increase in purchases of funds-of-funds and bond funds.

Its a positive thing that people have learned lessons from the bear market and are becoming more effective in rebalancing their portfolio and asset allocation, said Mathew Greenwald, president of research and consulting firm Greenwald & Associates of Washington.

Narrower sector funds, such as technology and real estate funds, have not seen large inflows of money. Emerging market funds experienced high returns and inflows in recent years, but their gains accounted for only about 15 % of all international equity fund net flows last year and under 10% in 2005, Strategic Insight found.

On the other hand, investing in international funds has increased significantly. International equity fund inflows exceeded $100 billion in the first half of the year. There is greater focus on international funds, and people are realizing that they should have investments in non-U.S. funds, said Nachmany, who predicts the shift toward a higher allocation of portfolios to non-U.S. funds will continue. Investors are realizing that they need more of an appropriate mix, he said.

Over the past five years, international funds have outperformed U.S. funds by 45 percentage points. Investors are chasing returns, and globally the market has done better, said Niels Holch, executive director of the Coalition of Mutual Fund Investors of Washington.

Financial advisers and retirement planners are ensuring that investors are more diversified. Forces driving the asset allocation are compliance concerns, regulatory prudence, product innovation and distributor and financial adviser advice. Advisers are pushing solutions, not products, said Owen Concannon, an analyst with Boston-based at Financial Research Corp. The model has changed and mutual fund wraps, SMAs, lifecycle funds and new products are being bought into the mix, he said.

Inflows to mutual fund wrap accounts exceeded $50 billion in 2005, and similar targets are expected this year, according to the report. The process has become more institutionalized, and its not the art of selling, now its the science of selling, Nachmany said.

In recent years, fund ownership turnover has been low and stable, mirrored by redemption rates that are at the lowest levels experienced in modern history of the mutual fund industry. However, a majority of the money is in retirement funds, which is usually not reallocated by investors, experts pointed out.

For large, actively managed equity funds, commission costs in recent years have generally declined, as fund sizes have increased and turnover has slowed. Between 2003 and 2005, 13 of the 20 largest actively managed funds saw their brokerage commission costs decrease by more than 30%, with the median decreasing 35%. Only one firm out of the 20 experienced a rise in its commission ratio for the two-year period. Commission rates will continue to fall as the cost structure changes and there is increased transparency in the market, experts said.

An increasing number of small money management firms that tout good performance and low fees are capturing more assets from the market. Low-fee stock and bond index funds secured $81 billion in inflows last year. Many small managers that delivered high relative return, low relative risk and superior performance, grew rapidly last year, according to the report.

Investors want to invest in sustainable, good performing funds, and smaller funds that perform well will attract assets, Holch said.

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