Mutual Funds and a Changing Landscape
Kirk Shinkle

Pruning your portfolio? Some trends to watch

Investors can be a fickle lot. But for more than three decades, they've bought into one idea that has really never fallen out of favor: the mutual fund. These workhorses are in almost every investor's portfolio, and they continue to dominate the financial options available to Americans saving for college and retirement.Even as economic worries weighed on them -- a recession that just wouldn't end, a drop in global markets of more than half, and a jobless rate near 10 percent, to name three -- many investors focused on retirement held fast to their funds. A March study by Vanguard Investments found that less than 1 in 7 Americans made any change to their 401(k) retirement savings plans during the crisis. At the end of last year, despite the strains of one of the worst decades in market history, Americans held more than $11.1 trillion worth of assets in funds, up from less than $900 billion in 1989. During that time, fund ownership more than doubled to 50 million households.

Though the breadth of the market's devastation revealed that diversification is no guarantee of protection, for most individual investors "a sensible balance of mutual funds still makes a lot of sense," says Martin Gruber, the Nomura Professor of Finance at New York University. "People should be buying funds rather than trying to pick individual issues."

As they do, investors will find that they face a changing landscape. Shifting demand, new investment choices, and fallout from the downturn mean that the most common type of fund owned by average Americans -- equity funds run by a stock-picking manager -- will experience new competition. Demand for stock funds, which dried up during the recession, has barely reversed this year despite an ongoing market rally. "We've seen ongoing demand weakness in equity funds. It's picked up [recently], but overall demand for equities has been pretty weak throughout this recovery," says Brian Reid, chief economist at the Investment Company Institute. Here's a look at a few of the most significant trends people shopping for mutual funds now will want to consider:

Another Year of the Bond?

Stock funds remain by far the favorite of most investors; equity funds still held nearly $5 trillion in net assets at the end of 2009, far outpacing bond and money-market funds. But after the financial crisis, something changed. Despite a stock market that came surging back in 2009, bond funds have seen record capital flows recently thanks to opportunistic buying in the wake of the crisis, a fear-induced flight to safer assets, and, above all, interest rates that are expected to hover near zero for some time to come. Bond fund sales jumped 50 percent in 2009 to roughly $800 billion. A further 17 percent increase is forecast this year. "Bonds will probably be the story throughout 2010. We won't see a big obstacle for bonds until interest rates start to go up," says Loren Fox, an analyst with Strategic Insight.

Still, that doesn't mean bonds are a "buy." It's clear that 2009 will be remembered as a legendary year, when the average total returns of bond funds topped 16 percent as fund managers snapped up all sorts of bonds at bargain-basement prices during the credit crisis. That opportunity is largely over, and investing pros are growing increasingly wary of all sorts of debt as the current fixed-income rally cools and an eventual rise in interest rates, which will hurt bond prices, seems more inevitable. Some sectors, like municipal bond funds, have seen inflows slow noticeably already.

Longer term, the question remains whether more investors will stick with bonds when the economy rebounds. Some analysts, including Reid, argue that demographic shifts favor bond-fund demand as income-seeking baby boomers approach retirement. But stock funds have been resilient even after the past decade of middling returns. They've drawn the lion's share of investing dollars for years, and it's tough to predict a real break from that stock-loving tradition, analysts say.

New products rise.

The all-star fund manager is a fixture in the fund world. Names like Pimco's Bill Gross or Fidelity's William Danoff still grab headlines. But new types of investment products that cater to a growing interest in smart asset allocation rather than smart stock- or bond-picking, are giving the traditional mutual fund a run for its money. Active fund managers who can't beat their benchmarks are going to increasingly lose out, experts predict. "The do-it-yourself investor peaked in the late '90s," says Fox.

This decade, no rival to traditional funds has come on as strong as the exchange-traded fund.

These popular, low-cost index trackers hit a milestone in late 2009, when assets under management topped $1 trillion, soaring from less than $40 billion a decade ago, according to asset manager BlackRock. The passively managed funds, which follow everything from baskets of global stocks to gold, offer an attractive proposition: broad exposure to dozens of new parts of the market at a fraction of the cost of traditional funds. ETFs are already going head-to-head with actively managed funds that hew close to an index, bolstered by lower fees and the fact that they trade like stocks, at any time during the day (traditional funds trade just once a day). Experts say traditional funds that will face the most pressure from ETFs include large-cap domestic stock funds, especially those that have spent years comfortably mirroring major indexes like the S&P 500.

Target-date funds, another fast-growing option for investors looking for a simple way to diversify a portfolio, gradually shift to a mix of more conservative assets as a specified date of retirement nears; they offer a built-in asset allocation "glide path" designed to gradually decrease risk over time. Such funds drew ire in 2008, when some aging target-date investors were spooked by the amount of equity risk in their funds as markets sank. The outcry prompted a government call for improved risk disclosures by such funds. But the asset class appears to have weathered its first major test in respectable shape, if consumer demand is any indication. In 2009, new enrollees in company retirement plans put 42 percent of total contributions into target-date funds. The newly launched Fidelity Series Commodity Strategy Fund, used as part of the company's target-date portfolios, garnered some $2.67 billion in net assets in its first six months.

Interest in both ETFs and target-date products has been "off the charts," says Fran Kinniry, a principal of Vanguard. Their rise will continue to influence how investment companies shape their offerings. Big investment houses like Fidelity and Vanguard have broadened their mix of both active and indexed products. Some small money managers are building all-ETF portfolios, and a survey by Cerulli Associates shows that nearly half of advisers used ETFs in 2009, though only for a small percentage of assets.

A hiccup in fees' long decline.

Low costs have long been among the biggest selling points for mutual funds; average annual fees and expenses paid by mutual fund investors have fallen by half since 1990. Unfortunately, bad times in the economy and markets are also bad for fund fees.

Last year, fund expense ratios jumped to their highest levels since 2000, according to Morningstar. When investors pull their cash out in a panic and the size of a fund shrinks, the cost of running that fund remains fixed, so expense ratios can edge up. Another culprit: Many funds use so-called break points. For example, a fund could charge a 4 percent front-end sales load on an investment above $25,000, but up that fee to 5 percent for smaller investments. Some funds can raise such fees automatically if total assets fall below a certain level.

If it seems counterintuitive that funds would raise fees rather than cut them as investors raced for the exits, the process also works in reverse. As assets flow back, keep an eye out for announcements of lower fees among the more brazen funds.

Bottom line:

The price of ownership of mutual fund shares matters. Soon, those costs should resume heading down.

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