From the December 2005 issue of Investment Advisor • Subscribe!

Hybrid Vehicles?

Mutual funds have brought Main Street into investing and been the lifeblood of most advisors' practices. In the future, will there be a better way to invest?

For time immemorial (actually, around 25 years), this magazine has spotlighted each month a mutual fund. As we prepared for this anniversary issue and wondered whether there was one mutual fund we could dub the "Fund of the Future," we realized how difficult it would be to select just one fund. Moreover, we wondered, would it be a fund at all? What will the world of an advisor be like in 2030? Will there be stocks, bonds, and commodities? What about mutual funds, hedge funds, and REITs? Will geographic diversification include not only global, but interplanetary asset allocations? While we don't have a crystal ball, we have done the next best thing, talking with some of the wisest people in the investment business to get their points of view about the future of investing.

Understandably, there is some disagreement over exactly what the future holds for investors. Who would have predicted in 1980, when Investment Advisor was first published and the Dow Jones Industrial Average stood at 875, that the Dow would be at 10,600 in 2005, or that regular employees would, for the most part, have to manage their own retirement savings and investing? Could anyone have predicted in 1980, when mortgage rates were around 16% and you could buy a 10-year U.S. Treasury bond yielding more than 12.80%, that fixed-rate mortgages would be available in 2005 at around 5.5%, and that the 10-year Treasury bond would yield around 4%? And selecting a mutual fund? There were about 80 open-end funds to choose from in 1980; now investors have to select a fund and an asset class from the more than 23,000 available, according to Lipper, Inc. No wonder clients are overwhelmed by the complexity of planning their financial future. But that fact presents for advisors a golden opportunity to forge great relationships with clients who more than ever need comprehensive planning and advice.

Writing comprehensive financial plans is particularly valuable at a time when a change in the demographics of the country presage a shift from wealth accumulation to wealth distribution. Retirees will still need advice as they begin to take distributions, maybe even more than they needed during wealth accumulation.

Funding the Future

How has investing in funds changed? It has gone all the way from a "cloth cap to a top hat business. Initially it was for people of modest--but not too modest--means, and has evolved into a series of businesses that use funds that now impact, in some cases involuntarily, roughly half the households in the country," says A. Michael Lipper, founder and CEO of a Summit, New Jersey-based RIA, Lipper Advisory Services, Inc. Over the years, Lipper built a mutual fund research business, Lipper Analytical Services, Inc., which he sold to Reuters in 1998. He already addresses the coming leap in longevity by assuming a lifespan of about 120 years when planning for clients. "You always want to be slightly ahead. I've not seen an actuarial study, but I would tend to believe people who have significant investments--unless they do harm to themselves--live longer and certainly have more expensive later years."

No single fund is representative of the mutual fund business today, says Lipper, but in the future, broader types of assets may have a place in mutual funds, such as timber, commodities, real estate, or intellectual property. These types of assets "represent daily [NAV] pricing challenges, but if there is sufficient demand, this is a very creative community and they will find ways to measure it," according to Lipper. He sees mutual fund expenses going up. Why? He looks at expenses as the incremental cost to the investor of getting the investment serviced. One reason for higher expenses may be liquidity premiums on securities. As for stated expenses, if you define mutual funds as a business, there would be low-expense funds and high-expense funds, and the difference between the two is "not necessarily greed, but the level of service and the level of exclusivity," in minimum investment and type of investment. Among other developments, says Lipper, we might see more funds offered to specific segments of the investing population--religious affiliated funds, funds for employees of a certain company only, and funds with very specific risk tolerances.

There are changes coming in the labeling of mutual funds, too, suggests Lipper. "Labels [that are] used to name fund types--growth, value, balanced--don't tell the story, and will evolve," with a trend away from labeling funds on the basis of how they operate. He uses this example: When you go to the grocery store, you don't spend "value dollars" or "growth dollars," you spend money, and he expects that mutual fund labels will evolve to show more of what the benefit of the fund is to the investor.

A Huge Opportunity

Only "one out of five people over the age of 60 have done any type of financial planning, so they're going into retirement on a wing and a prayer," says Robert Reynolds, vice chairman and COO of Fidelity Investments. That means there is an enormous opportunity for planners to help some of the other 80% of those age 60 and over who do not yet have a financial plan. Asset allocation, diversification, and an understanding of clients' income needs in retirement are all essential to that plan. Fidelity, which has $1.1 trillion in assets under management, estimates that "investable assets of people over age 60 today are around $5 trillion; by 2012 it will be $20 trillion, and that's with only one-third of the baby boomers over age 60, so that will have a tremendous impact on the investment world." He predicts a demand for higher income-type products, including funds of funds that generate higher-than-standard income.

In addition to a map to guide them through their financial future, investors need a map of the world. "People have been very U.S.-centric, and anything outside is 'risk,' foreign is risk, emerging markets is risk, and what you're seeing, very dramatically--and it's accelerating--is the globalization of the world, and I don't think individual investors have really seen that yet," says Joan Payden, CEO, president and founder of the global mutual fund company Payden & Rygel, which has $50 billion under management. "When you talk to someone about investing in Europe or Eastern Europe [they say], 'Oh, it's risky.'" Payden thinks many Americans don't acknowledge that many of these countries have been around much longer than the U.S. and have economic and cultural structures that have withstood the test of time. "I think there will be a realization that the rest of the world is pretty sophisticated."

"The other thing that's converging is capital markets with new strategies [such as] portable alpha--where you have a bond fund, but you port the alpha to stocks," says Payden. "Over the next three to five years, one could find people looking at the world geographically, and looking at it much more globally," by including non-correlative characteristics to portfolios by diversifying both geographically as well as by asset type.

"All the forces, in the long term, point to a better outcome, a better equation, for the investor," says Don Phillips, managing director at Morningstar, Inc., in Chicago, of the future. "If you look at the last 20 years," he points out, "you see business practices that are hostile to the investor, [such as] high fees, and promoting short-term performance. Fund companies have made a lot of money in the short run doing that, but it always backfires. In the mutual fund industry, putting the investor's interests first is not only a winning business strategy, in the long run it's the only winning business strategy," says Phillips. He says the fund companies that are big winners are not necessarily load or no-load, but have common attributes. They provide a winning value proposition to the investor; didn't get caught up in the scandals; provide a lower cost relative to their distribution channel--with reasonable fees relative to the services that they provide; and didn't get caught up in faddish products that may have good short-term gains but tend to blow up on people, says Phillips. "There will always be people who are tempted to chase the hot money, but at the end of the day, you end up as a fund company with the shareholder base that you deserve. If you promote your funds on short-term performance, you'll get a very fickle and demanding hot money client database, and that's not a great way to build a business."

Phillips argues that in some ways the fund of the future is already here with an exchange-traded fund. "A big advantage of exchange-traded funds," he points out, "is you get the distribution cost out of the mutual fund equation." He says that the proliferation of share classes is a huge disservice to the investor as well as the planner because the explanation of A shares versus C shares and all the other share classes is crowding out the "What are your goals?" conversation that should be happening between the client and the planner.

Broadening the Definitions

Creating portfolios that include broader types of asset allocations--including hard assets like gold or commodities--is a recurring theme among experts pondering the future of investing. But nobody is asking investors or planners to make timing decisions themselves. Instead, what may make the most sense is an asset allocation fund that includes multiple assets including hard assets and TIPS, but doesn't ask the investor to make the timing decisions, argues Phillips. That way, investors get the benefits of the non-correlative model in a fund that includes a much broader spectrum of assets, but in which timing is left to professionals.

Phillips says the answer isn't "hedge funds with absolute returns [but with fees of] 2% and 20%--that's a ripoff, but I think you can create something that has more absolute return-like characteristics," in a mutual fund. "Look at Jean-Marie Eveillard at First Eagle SoGen. He had funds that, in essence, did that and they were beloved by financial advisors. I think you'll see more funds that try to do that, might include gold or more commodity-oriented investments as part of a balanced portfolio. But you've got a whole generation of stockpickers that grew up being told 'Those aren't winning areas,' and all their skills are in picking more traditional main-line securities, so I think that will have to change."

Phillips agrees that one challenge for fund companies will be creating that stream of income for people who expect to live far longer in retirement; the interests of fund companies and the interests of their investing clients diverge here. "In the accumulation phase of investing, investors' interests and the interests of the fund management company are completely aligned," says Phillips, but as distributions start to occur, the mindset of the fund companies, with assets flowing out, has to change. Phillips says, "those groups that make the change first will be the winners. Fidelity's Retirement Income Planner is a brilliant move," toward that end. "This is going to be a very tangible way for advisors to prove their worth because the results will be much more tangible when it's a check in the mail every month, as opposed to sitting down every six months to look at a statement."

Life Remains in Mutual Funds

Well, then, are mutual funds dead? "I don't think so, they are a great vehicle for delivering returns to investors, they're convenient ways to take advantage of efficient pooling of assets," says Ben Warwick, CIO of Sovereign Wealth Management in Denver and a regular IA contributor. He believes that some of the changes going forward will be in how funds are managed. People want to match their liability stream with an asset stream. With "risk-managed investing," for instance, a fund with 6% annual standard deviation might be used to match liabilities for someone who wants to pay off a home in a certain number of years. Funds like that exist now in the hedge fund world, and Warwick thinks that type of fund will be available as an open-end mutual fund. "Why do people invest money? They invest it because they have these objectives in the future. We need products that directly address those objectives, and those are the kind of products that we'll see over the next 25 years." Warwick thinks we will see more of a balanced type of fund that contains an equity component, even if the emphasis is on fixed income, for people who need their assets to last through longer-retirement years.

One thing that advisors really need to focus on now is assessing investors' risk tolerances--and there is technology available that can be useful for those assessments--because "the central task of wealth management has really become risk management; you have to effectively marry the risk tolerance of an investor with a portfolio so that if something happens, they're not going to bail out at the worst possible moment," says Warwick.

Future Shock

Some major challenges remain, bubbling up but not quite at the boil yet. One of those is the issue of how much money investors can withdraw from retirement accounts while ensuring that their money won't run out. Some people may need more than 4% to live the life they want to, and funds that combine capital appreciation and income may have a place in that thinking, according to Fidelity's Reynolds, "What we're seeing is that Generation Xers are saving more for retirement at an early age than the baby boomers did. They are allocating more aggressively." But there are a number of additional steps that Fidelity is doing to make it easier for investors to save and invest for retirement, or at least make it harder to ignore their retirement accounts. Among other initiatives, Fidelity is working with companies to make their defined contribution plans "opt out" instead of "opt in"--making employees' deferrals to companies' qualified retirement plans automatic unless the employee specifically says no. Plan providers are also adding automatic escalating percentages that would each year defer a higher percentage of income to retirement accounts unless the employee opts out. Fidelity is revamping its own retirement plans in this way starting in 2006.

A related initiative at Fidelity is "Beyond Wealth, Health," says Reynolds. "People need to realize that cost of healthcare in retirement is, by our estimates, $180,000 during retirement, and going up. Clearly there is a real issue with Medicare and what it can and cannot do in the future." And it's a critical consideration in any comprehensive financial plan.

Not all of the big future-of-investing issues relate directly to clients; some are advisor or money manager issues. According to Lipper, the biggest issue facing advisors is succession: Who will replace them, as well as who will replace good money managers. When advisors want to institutionalize their firm, they have to bring along their replacements, yet they may be decades from retirement. This can mean long-term contractual obligations that might create "very significant liabilities," says Lipper. Still, taking the time to think about this issue is very much a part of investing in the future.

Staff Editor Kate McBride can be reached at kmcbride@investmentadvisor.com.

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