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Mutual funds riding high, but many wary of a fall

Published Oct. 13, 2005

The mood was jovial as mutual fund executives gathered in record numbers at their annual convention sponsored recently by the Investment Company Institute. Last year, fund assets exceeded $1-trillion for the first time. But the merrymaking in Washington was punctuated by a few sour notes.

The industry must watch its step or it could fall from grace as profoundly as the once-fat savings-and-loan industry, warned James S. Riepe, managing director of T. Rowe Price Associates Inc. and the new chairman of the ICI. "The biggest challenge to any successful business is complacency," he told the 1,400 conferencegoers.

Many in the audience had no memories of the last time the industry fell on hard times, a victim of the stock market decline starting in 1973. By 1974, assets had shrunk to $34-billion, only about half what they had been just two years earlier.

Recovery was slow. Assets did not return to their 1972 levels until 1979.

Since then, however, mutual funds have had an almost unbroken run. Aside from the rise in assets and an explosion in the number of funds, to 3,000-plus from 400 in the mid-1970s, many in the industry have enjoyed immense profitability.

While the annual return on equity of brokerages has ranged from 6 percent to 15 percent, large mutual fund organizations have enjoyed returns of 20 percent to 50 percent, said Michael Goldstein, an industry analyst with Sanford C. Bernstein & Co.

Perhaps because of this, pressures are building on the industry from banks and brokerages, eager for a share of a very profitable pie, and from international investment firms moving into the United States. As one executive put it, "If everything's so great, why are we so worried?"

One big challenge facing the industry is maintaining the integrity of money-market funds.

Equity funds made up 75 percent of assets when the stock market dropped in the '70s, showing the industry's vulnerability to such declines. Today, stock funds make up only 25 percent of assets. Bond funds hold another 29 percent, and the rest of the assets are in money funds.

That may be the industry's Achilles' heel. As money continues to pour into money funds, managers will find it increasingly difficult to find suitable investments. The Securities and Exchange Commission has passed tough regulations, which took effect last week, that tighten the standards for money-fund investments, but such investments are not risk-free.

In the last two years, several issuers have defaulted on commercial paper held by money funds. In all cases, the fund sponsors covered the losses.

That may not be possible as losses become larger or if sponsors decide it is too costly.

Goldstein, for one, believes sponsors ultimately must let money-fund investors bear the losses from commercial-paper defaults.

"The de facto guarantee on money-market funds increases the risk for the whole industry," he said.

At the fete, the industry toasted its long-time leader, David Silver, who is retiring this fall after 15 years as president of the ICI.

But in his last speech to the group, Silver had a mystifying message. He addressed industry executives almost as if he were struggling to keep bickering children from breaking into a free-for-all.

The industry must remain united, or "we will become as ineffectual as other associations whose energies are sapped and whose efforts are stunted by internecine bickering," he said.

When questioned about the speech, Silver said he feared members increasingly were divided on matters of policy and regulation. He simply was encouraging members to accept the group's positions, he said.

Another significant topic of discussion at the gathering involves pricing policies. After little change for 50 years, pricing has become an important component of marketing as funds experiment with new charges in an increasingly competitive marketplace.

For many investors, the mix of upfront sales charges, exit fees and 12b-1 fees, which let funds pay a portion of their marketing expenses from fund assets, is difficult to sort out.

"That's unfortunate," said Don Phillips, vice president of Morningstar Inc., Chicago-based mutual fund consultants. "Some of the simplicity of fund investing is getting lost."

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