Mutual Fund Meltdown

By Daniel Eisenberg

What's the point of paying a professional to manage your money when you can do just as good a job, if not better, on your own? That was the question Hillsboro, Ore., computer consultant Larry Taylor, 40, and his friends asked themselves three years ago. Sick of sitting on the sidelines of a raging bull market, watching individual stocks skyrocket as their mutual funds crawled along, Taylor's crew decided to take matters into their own hands. Pooling assets, they chose a diversified portfolio of tech, pharmaceutical and manufacturing stocks and have enjoyed 30% annual returns ever since. "We got tired of seeing fund managers getting rich and fees getting paid," says Taylor. "Mutual funds are for people who want to put their money into the market and just forget about it."

But with everyone from bellhops to biologists following every blip in the Dow on cable-TV channels and financial websites, passive investing is starting to become passe. "Everybody's an expert," grumbles a high-ranking executive at one fund company--a reference to the growing legion of e-traders who are sucking money from money managers at a rate that is starting to test their nerves. Sure, the $5.9 trillion fund industry is still chugging along quite nicely. But after a decade of explosive growth, it seems poised for a shakeout, as too many stock funds (about 3,500 at last count) scramble for a slowing money supply.

In the first four months of this year, $52 billion in net new money flowed into stock funds--down a third from 1998's record levels. Moreover, as fund investors chase short-term performance above all, only a select group of the top fund families, with brand names like Vanguard, Janus, Fidelity, Putnam and Alliance, are capturing the bulk of that new cash--and much of it is "automatic" in the form of 401(k) plans. That leaves hundreds of smaller players to fight for the scraps, according to Financial Research Corp. "There's a lot more risk now," says Jack Brennan, chairman of fund giant Vanguard, based in Valley Forge, Pa. "People may be looking for bigger, more seasoned names with a broader array of products. Or the investor may be making a bit of a market call, taking some risk off the table."

In April, always a strong month because of tax refunds and IRA contributions, a net $25 billion flowed into mutual funds, according to the Investment Company Institute. But that's down slightly from last April, and this year income tax refunds were at record levels. And thanks to a 2% across-the-board drop on Wall Street during the month, May is looking like a loser, with just $10 billion flowing in, according to market tracker Trim Tabs.

The thinness of the market--most of the past year's gains can be traced to relatively few stocks--has been tailor-made for the e-trade crowd, who pile into favored stocks at light-speed. It's been a hot-money, risky environment, and these investors have apparently lost respect for the traditional, research-oriented investing that the pros have to offer.

Who can blame them, considering the sorry record of most fund managers? With less than 20% of active managers outperforming the market, it is understandable that last year, for the first time ever, asset growth in individual stocks outpaced that of funds at discount broker and fund supermarket Charles Schwab. Or that No. 1 Fidelity has been stepping up promotion of its brokerage services, as more customers have looked to open hybrid portfolios made up of stocks and funds. "This industry has grown so rapidly that there is a shortage of good managers," says Bridget Macaskill, CEO of Oppenheimer Funds. "But mutual funds are fundamentally a good tool for small investors."

The fund industry is praying that the online trading boom and focus on just a few stocks (America Online, Amazon, eBay, Yahoo, Cisco) is a short-term phenomenon, the sign of a cyclical market that has got out of hand, rather than a fundamental, long-term shift. "It's based on a false sense of empowerment," claims funds watcher Avi Nachmany of Strategic Insight. Once the narrow bull market calms down, or broadens to include harder-to-choose value and small-cap stocks (as it appears to have done of late), Nachmany and others argue, investors will rush back to the relative safety of a diversified mutual fund. "Investors have abandoned the risk side of the equation, but it's not sustainable," says Greg Johnson, president of Franklin Templeton Distributors, a $155 billion fund family that has lost $7 billion of cash this year as investors fled its faltering value and international funds. "There are more than 10 good ideas for investing."

Unfortunately for the industry, one of the most popular ideas, at least for now, is to have practically no manager at all. Nearly one out of every five new investment dollars is now going into low-cost index funds, which automatically mirror the performance of benchmarks like the Standard & Poor's 500. Already this year $18 billion has flooded into Vanguard, the behemoth that pioneered the practice. Says John Rekenthaler of funds researcher Morningstar. "Indexing is an ongoing challenge that most of the competition is not facing up to."

It's no surprise, then, that much of the competition isn't faring too well either. Close to half the 600 or so mutual fund families experienced net withdrawals in the first quarter of 1999, and floundering funds were merged out of existence at a record pace last year, according to Lipper Inc. Once-high-flying firms such as Stein Roe, Pilgrim Baxter and Berger Associates are reassigning dud managers and hustling to attract new money. Says Stephen Cone, president of customer marketing at Fidelity Investments. "We're not going to see the phenomenal growth of the past, and that may be an alarm bell for smaller firms. Their jobs have got much harder."

They may soon have no jobs at all. Some observers think that within a decade, more than half the 600 fund companies could disappear, as outfits with less than $50 billion in assets become ripe for the picking. With the big boys dominating the highly profitable institutional side of the business--401(k)s and other retirement plans--and much of the growth now coming from market appreciation, it will be hard for a second-tier player to shine.

Certainly, some of the smaller outfits will make it--there's always room for niche players, as the rise in focused Internet funds proves--but it is likely that the business will never again have the same kind of lock on the retail investor. Jokes veteran portfolio manager Martin Whitman of the Third Avenue Value Fund: "You haven't seen a more speculative, irrational market in years. The inmates are running the asylum." The industry just hopes that, sooner or later, it can get them back in line.

--With reporting by Dan Cray/Los Angeles

With reporting by Dan Cray/Los Angeles