From Complexity to Simplicity And Back

In 30 years, the mutual fund business has evolved from simple products to a mind-boggling array of options. The latest twist: back to basics

Ask yourself this: In 1976, would you have bet on mutual fund managers? Remember, in those days, the outlook for money managers seemed bleak indeed. Though the market had rebounded somewhat from the 1973-1974 debacle, assets in mutual funds totaled just $51 billion down from a high of nearly $60 billion in 1972. Retail investors were withdrawing money from stock and bond funds; institutional money headed into real estate, oil and other hard assets.

The separate account business, in its infancy, was for institutions or the super rich — only investors with more than $5 million — and even then there were few takers. (The Money Management Institute doesn't have cash-flow numbers, but veterans say the retail business for SMAs was small.) It would be years before SMAs would become the vehicles we take for granted today.

In 2006, mutual funds are owned by 54 million American households. They hold $9.3 trillion in assets. Retail investors have $736 billion in separate accounts. All the forms of management are gaining new assets and introducing new products. The average retail client and his advisor are now more sophisticated than ever. And retail investors with a just few thousand dollars can follow strategies that once seemed arcane, like, say, buying silver or holding Austrian stocks. Many advisors are seeking to follow the lead of institutions, using mutual funds and ETFs to build broadly diversified portfolios. Make no mistake, portfolios of typical retail investors do not match the complexity of the most sophisticated endowments and pensions. But the gap is closing. “Soon more advisors will be using techniques like leveraged funds, commodities and foreign currencies,” says David Reilly, director of portfolio strategy at Rydex Investments.

Roots of Growth

Back in the late 1970s, only a handful of mutual fund companies had sizable retail followings: Pioneers included Dreyfus, T. Rowe Price and Oppenheimer. They offered broad portfolios consisting of blue chips or balanced offerings (holding a mix of stocks and bonds). There were few international funds and none specialized in real estate.

Then Fidelity and a few other companies began attracting attention with small-cap growth funds that were outstripping the sluggish market. More investors began noticing that top fund managers could deliver big returns. In 1982, the Dow Jones Industrial Average again broke through 1,000 and began what would prove to be the greatest bull market in history. Companies began introducing funds specializing in sectors like technology. By 1983, there were 1,000 funds with $292 billion in assets. Perhaps the greatest impetus for growth came in the 1980s when the government created 401(k) plans and liberalized the rules for individual retirement accounts. The new programs encouraged savers to buy mutual funds year after year, regardless of how the markets might be doing.

We are at a similar turning point today, with a wave of innovation swamping financial advisors, from fundamental indexes (see page 67) to inverse index funds. Using plain-vanilla mutual funds, retail advisors can build low-correlating portfolios, like absolute-return portfolios. In fact, the sophisticated financial advisor is performing like a mini-institutional consultant of yore.

Ouch! I Learned Something

In the 1990s, 401(k)-savers discovered that stocks could deliver amazing returns. And, of course, they were soon to discover that stocks could also deliver sudden losses. The red ink that began appearing in 2000 ushered in an era of caution that still dominates funds. In 2005, moderate allocation was the fastest-growing Morningstar category; it includes traditional balanced funds and other portfolios designed to avoid big losses. For the year, moderate allocation had net inflows of $58.6 billion, while large growth — the star category of the 1990s — had outflows of $4.8 billion, according to Financial Research Corporation. “As investors have become more aware of risk, they are focusing on funds that are more diversified,” says Dennis Ferro, president of Evergreen Funds.

Among the new breed of cautious choices are so-called lifecycle funds. Designed for retirement savers, lifecycle funds are complete portfolios, including a balanced mix of growth and value, stocks and fixed income. The portfolios come in a variety of styles, including conservative, moderate and aggressive packages. The funds have been around for a decade, but lately their growth has been eye-popping. Annual inflows to lifecycle funds jumped from $8 billion in 2001 to $45 billion in 2004 and $60 billion in 2005, according to Strategic Insight. In the first half of 2006, sales will come in around $60 billion, the research firm predicts.

Is the shift to balanced and lifecycle funds a fad, an effort by investors to grab the latest hot thing? No, says Avi Nachmany, research director of Strategic Insight, a fund tracker. “This is not a temporary trend,” he says “People are buying diversified packages because they are worried about retirement and they do not want big losses in a downturn.” (Whether investors use them correctly is another story.)

T. Rowe Price reports that its fastest-growing new product introduction in history is a version of lifecycle funds known as retirement-date funds. With these, savers pick a fund that is aimed at a year close to their retirement date, such as 2020. The fund manager assembles a package of stocks and bonds that is best suited for the average person retiring that year.

The retirement-date funds are one-size-fits-all investing. In contrast, older lifecycle funds require investors to decide whether they are conservative or aggressive.

The retirement-date funds could be seen as an admission of failure by the fund industry. For years, fund companies tried to educate investors about the need for diversification. But many investors showed no interest in listening to the message. A big percentage of investors could not even answer whether they were conservative or aggressive. With retirement-date funds, investors need only figure out what year they plan to retire; no other decisions are required.

For advisors, the retirement-date funds could pose a challenge. If a client puts all his assets in one fund, then he may not need much advice. But some advisors have embraced the retirement-date funds, according to T. Rowe Price reports. Advisors have found that lifecycle funds make good choices for small accounts or as core holdings. By relying on the off-the-shelf portfolios, advisors can efficiently serve many smaller clients. The lifecycle funds allow advisors to spend more time on what many do best, providing comprehensive financial planning, the fund manager says.

The Need for Complexity

Besides offering retirement-date portfolios, fund companies are developing other packages that reduce the need for decision-making. Some new funds are aimed at the growing retirement market. A recent entrant is MFS Diversified Income, which could offer a convenient way for retirees to make sure that they have enough cash to pay monthly bills. The MFS fund keeps about 30 percent of its assets in dividend-paying value stocks and real estate investment trusts, which provide income and some potential for growth. The rest of the fund is in a mix of bonds that includes high-yield corporates, Treasuries, agencies, emerging-market debt and cash. The current yield is 4.5 percent. “People want their lives to be more simple,” says James Jessee, president of MFS Fund Distributors. “With a diversified package, you dampen volatility and save people the work of having to sort through a lot of different asset classes.”

While many investors complain that there are too many new funds, at least some advisors argue the opposite. “We need to have a lot more specialized funds constructed,” says Louis Stanasolovich, president of Legend Financial Advisors, a registered investment advisor in Pittsburgh.

For years now, most advisors have been content to run relatively simple portfolios built along traditional lines. A typical asset allocation might have 60 percent in stocks and 40 percent in fixed income. Now some advisors say that retail clients with sizable portfolios should have the same kind of diverse portfolios that leading institutions run. Endowments such as Yale and Harvard have produced outsized returns by maintaining portfolios that only have 40 percent or less in equities. Most of the remaining assets are in a broad range of holdings, including hedge funds, commodities and currencies. “The top institutions don't want to rely heavily on equities because they are volatile,” says Howard Horowitz, research director of Arbitrage Fund. “The right hedge fund can deliver better returns with not much risk.”

Retail investors don't have access to top hedge funds, but there are a growing number of mutual funds that act like hedge funds. A strong choice is the Arbitrage Fund, which buys shares of companies that are about to be taken over. During the past five years, Arbitrage Fund has returned 4.3 percent a year, outdoing the S&P 500 by more than 2 percentage points annually, while taking on much lower risk as measured by standard deviation.

Another top hedge-like fund is James Market Neutral, which sells stocks short. James has also bested the S&P in the past five years while posting low volatility.

Some analysts have said that hedge-like funds may face steep competition from exchange-traded funds. Because they trade on exchanges like stocks, the ETFs can be sold short and used to hedge portfolios. First introduced in 1993, ETFs have been growing rapidly. In one seven-day period this June, more than 40 new ETFs were announced.

So far, ETFs remain a relatively small part of the investing universe. Still, they present intriguing tools for advisors seeking to emulate institutions. One of the most noteworthy new products is the Rydex group of currency ETFs. With Euro Currency Trust, even a small investor can hold the European currency. Other Rydex ETFs hold Swiss francs, Mexican pesos and Australian dollars. Institutions have long held currencies. The currencies provide unusual diversification because there is little relationship between currency movements and changes in U.S. bonds and stocks. In addition, holding foreign currencies can provide a hedge against a fall in the dollar, something that many analysts expect.

Along with holding currencies, sophisticated investors have often relied on leverage. In a simple form, a hedge fund may invest $1 in options that enable the manager to control $5 worth of stocks. If the stocks rise, the hedge fund will skyrocket. Unfortunately, leverage can backfire in downturns when it magnifies losses. Because of the hazards of leverage, many advisors have avoided it. But a new generation of ETFs and funds may now make it possible for individuals to follow strategies that have enriched the big college endowments.

Consider Rydex Nova, a fund that uses derivatives to deliver 1.5 times the return of the S&P 500. If the S&P goes up 2 percent one day, Nova will rise about 3 percent. That is terrific in a bull market, but bad news when the bears roar. To manage risk, endowments that use leverage keep it under tight control. Individuals should do the same, keeping strict asset-allocation limits. If an individual puts 10 percent of assets in Rydex Nova, then he should be careful to hold that target by rebalancing quickly. Perhaps the investor should sell Nova shares when the holding rises to 13 percent of the total portfolio. In another leveraged strategy, say that the investor wants to put 30 percent of assets in the S&P 500. Instead of buying a conventional index fund, the client could put 20 percent of assets in Nova. The other 10 percent could be spread among cash, precious metals and currencies. The final portfolio would have exposure to blue-chip stocks while enjoying the kind of diversity that has produced top gains for institutions.

Managed Account Innovation

Like mutual fund companies, providers of managed accounts are seeking to offer more sophisticated diversification. The early separate accounts aimed at retail customers were simple vehicles. In 1975, Jim Lockwood, an E.F. Hutton broker, began charging clients 3 percent of assets to have several managers oversee portfolios. As more money managers joined the programs, investors had greater choices. Today a typical client may have managers with half-a-dozen investment styles, including growth, value, international and various fixed income specialties.

Now some separate account managers are looking for greater diversification, says Len Reinhart, president of Lockwood Advisors, which provides separate account platforms. Some of Lockwood's accounts now include commodity funds, ETFs, real estate investment trusts and hedged mutual funds. “The separate account is evolving from the traditional stock and bond holdings to something much broader,” says Reinhardt.

Separate accounts should continue growing at their current annual pace of about 7 percent says Steve Deutsch, director of separate accounts for Morningstar. But Deutsch cautions that too many accounts are not focusing on what originally made them attractive. In a separate account, the investor owns each security outright. Because of that, a client can sell a losing stock to book a tax loss. In addition, the portfolio can be customized so that a technology executive need not hold stock in his own company. But Deutsch estimates that only 30 percent of separate accounts are run for maximum tax efficiency and appropriate customization. “In separate accounts there is an unrealized promise,” he says. “Money managers of all kinds need to focus on the basics, such as tax efficiency and lower fees. That will enable the management industry to keep growing quickly.”

Funds That Are Not Plain Vanilla

Fund Ticker 1-Year Return 3-Year Return 5-Year Return Maximum Front-End Load
Arbitrage ARBFX 7.2% 4.2% 4.3% 0
James Market Neutral JAMNX 1.1 8.4 4.2 0
MFS Diversified Income DIFAX NA NA NA 4.75%
Rydex Nova RYNVX 9.2 15.0 -0.8 0
Source: Morningstar. Returns through 5/31/06.

The Skyrocketing Mutual Fund Industry

Year Total Assets Number of Funds
1975 $45.9 billion 426
1980 134.8 564
1985 495.4 1,528
1990 1,065.2 3,079
1995 2,811.3 5,725
2000 6,964.7 8,155
2005 8,904.8 7,977
Source: Investment Company Institute
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