Hybrid Vehicles?

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.