The bell tolls for mutual funds

The mutual fund’s reign as the investment of choice is headed for collapse.

So says a new report by Forrester Research Inc. of Cambridge, Mass. The brief report, called “The End of Mutual Fund Dominance,” predicts more than $1 trillion will flow out of funds over the next 10 years.

Where will all that dough go? Into Internet-based alternatives, including separate accounts and fractional-share stock portfolios, according to the report.

It also predicts that by 2010, those new investments will be grabbing up 20% of all new assets invested. Mutual fund assets now stand at more than $6 trillion.

“I don’t think this is rocket science,” says Jaime Punishill, the Forrester analyst who wrote the report.

“These methods offer better ways to do what mutual funds try to do.”

But among industry watchers, Forrester may be alone in its reasoning that those options spell disaster for the fund industry.

“I think that several of these ideas are good for the industry,” says Eric Jacobson, a senior analyst at Morningstar Inc., the Chicago fund tracker. “But I don’t know that any of these, individually or collectively, threaten to topple the mutual fund industry.”

The reason, Mr. Jacobson says, is that the mutual fund structure works fairly well.

“It isn’t perfect, and investors have some legitimate complaints,” he says. “But the concept is still a pretty good one.”

That is, funds give investors access to professional money management at a relatively reasonable cost.

Much of Mr. Punishill’s argument is based on the idea that online separate accounts and custom-made stock portfolios — where investors buy and sell fractional shares for a low fee — come with the benefits of fund investing but avoid the headaches.

Among some fund problems are taxable capital gains distributions and lack of investor control over what stocks are in the fund.

Yet many industry watchers view these online alternatives as options that appeal only to do-it-yourself investors or frequent traders.

In fact, Tower Group in Needham, Mass., also recently issued a report about the bite that those new investments will take out of funds – $25 billion by 2003.

But the Tower report includes a big qualifier. “With so much money flowing into [funds], and so many retirement investors employing the buy-and-hold approach, … it is unlikely that personal portfolios will steal a significant amount of assets from the mutual fund industry,” the report concludes.

“If you examine these only as self-directed vehicles, then Tower is right,” Mr. Punishill says. “But we’re not predicting the rise of self-directed investors.”

He says the appeal is going to come when financial services companies couple these online options with advice and active management – two things the majority of investors still seek out.

“Enterprising companies are going to realize that these are superior vehicles to solve the same problems in a better way,” Mr. Punishill maintains.

move by e*trade

E*Trade Group Inc. in Menlo Park, Calif., for one, agrees. In July, it bought Electronic Investing Corp. of San Francisco, whose central product will be online, custom-made or prefabbed portfolios of fractional stock shares.

On the other side of the country, Foliofn Inc. in Vienna, Va., which already sells these fractional-share portfolios, has gotten a lot of attention this year. It’s partly due to founder Steven M.H. Wallman’s previous position as a member of the Securities and Exchange Commission.

But also, Foliofn’s portfolios – dubbed folios – provide benefits missing from mutual funds: control over which stocks are owned, the ability to buy and sell stocks to control tax liability, and unrestricted trading for a flat fee.

The company also is marketing its folios to institutions and advisers, one way Mr. Punishill expects those types of portfolios to reach a broader market.

On the online separate account side, MyMoneyPro.com in Sunnyvale, Calif., and RunMoney.com in San Diego allow investors with minimums of $50,000 and $100,000, respectively, to access professional money managers.

For its part, the fund industry’s chief trade group insists it is not threatened by those alternatives, even though it asked the SEC in the summer to regulate folios as funds.

“We feel that investor protection is just as critical in an electronic environment as in a paper one,” says Chris Wloszczyna, spokesman for the Investment Company Institute in Washington.

“Unless these kinds of products are comparably regulated to provide investor protection, there’s the potential for abuse down the road.”