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Mutual Funds Struggling to Keep Investors

Lawrence Carrel

Next year, the first baby boomers will turn 62, making them eligible to collect Social Security. Over the next 15 years, they will be followed by 76 million more. When this happens, many will switch from saving for retirement to drawing down their savings -- cashing out of mutual funds in the process.

Already, the fund industry is largely dependent on market appreciation for growth -- despite a rocky year, the S&P is up 5.6% to date.

There were $12.356 trillion in assets in mutual funds at the end of October, the most recent data available from the Investment Company Institute, a Washington, D.C. trade group. That was up almost 19% from the end of 2006. But most of the increase, which includes stock funds, hybrid funds, long-term bond funds and money market funds, has come from market appreciation.

Just $229.86 billion of the $1.94 trillion of growth represents new money.

Many of the industry's best-selling products, such as target funds, lifecycle funds, and funds in 401(k) plans, help investors plan for retirement. But they don't offer a systematic way to distribute money.

The traditional way the fund industry has catered to retirees is through annuities. These are insurance contracts that pay a guaranteed stream of income, typically by investing the premium in some kind of mutual fund. But annuities are a tough sell; they are complex and come with big fees.

Some firms, like Fidelity Investments and the Vanguard Group are targeting this market with mutual funds designed to provide retirees with regular income.

"These new products have some characteristics of annuity products, but without the insurance wrapper," says Jeff Tjornehoj, senior research analyst at Lipper, a fund research house. "They pay out 3% or 5% or 7% of the account every year. You get something that will pay out income, a certain percent of your total account balance over course of year, but isn't sold by an insurer and it's cheaper than an annuity."

The fund industry also has to contend with pessimism about the U.S. economy as well as competition from exchange-traded funds. Vincent Deluard, global equity strategist at TrimTabs Investment Research in Sausalito, Calif., notes that U.S. stock funds saw money walk out the door for seven straight months this year, losing a net $69 billion.

He says investors haven't pulled that much money out since 2002, in the throes of a bear market.

Deluard attributes the redemptions to pessimism about the U.S. economy -- investors added a record amount of money to bond funds this year, which he says is a measure of bearishness. They're also buying record amounts of global equity funds, and in particular emerging market stock funds, which have been benefitting from a weak dollar.

To some extent, investors are also moving money out of U.S. stock funds into exchange-traded funds, which are more tax efficient and more liquid than mutual funds, Deluard says.

ETFs are baskets of stocks that trade on an exchange. Investors own the underlying securities that correspond to their shares. So they only incur taxes when they sell the shares at a profit.

By comparison, mutual funds are pooled investment vehicles, and investors can incur taxes whenever a manager sells stock in the underlying portfolio -- regardless of how long they have owned the fund shares.

Also, funds can only be bought or sold once a day at the closing market price, while ETFs can be bought and sold throughout the day.

The mutual-fund industry has responded by lobbying for changes that would help it compete better. The first piece of legislation, which was introduced in Congress this past summer, is the GROWTH Act. It would defer the taxation of automatically reinvested capital gains until fund shares are sold. The bill was referred to the House Committee on Ways and Means on June 20, where it is currently pending.

The fund industry is also lobbying Congress to change the tax treatment of exchange-traded notes, another kind of investment vehicle.

There are other changes in store for the fund industry. The Securities and Exchange Commission has proposed improvements in the way mutual funds disclose information to prospective shareholders. The proposed rules assume investors don't read the prospectus when they buy a fund. They would require funds to offer an easy-to-understand summary of key details at the front of the prospectus, including investment objectives, strategies, risks, costs, the top 10 holdings, portfolio managers, broker compensation and tax information.

The proposed rules would also require funds to make the full prospectus available on the Internet in a user-friendly format.

The SEC is currently seeking comments on this proposal.