Mutual Funds Wake-Up Call

For all the talk about high management fees, tax inefficiencies, high turnover and long-term under-performance compared to major market indexes, the mutual fund industry has enjoyed a steady dose of cash inflows over the past decade. Even the explosive growth of exchange-traded funds (ETFs) and hedge funds has failed to bring balance to the marketplace.

This all is due to the favorable position of mutual funds in employer-sponsored retirement accounts, such as pension and 401k plans, and the well-oiled marketing machine behind many funds that aims to educate investors on the advantages of managed portfolios without revealing their numerous flaws. The question is: Can this market dominance continue? I believe it can, but only if the mutual funds recognize the changing needs of their customers and leverage the latest technology to add value to their product. If they don't, innovative investment vehicles will continue to gain market share until a new leader emerges from the pack.

Changing Needs of Customers

With the availability of many alternative investment vehicles - from ETFs to debt and equity derivatives to currency hedges - the share of mutual funds as a percentage of the average investment portfolio is bound to get smaller over the next few years. As a result, investors will require a new level of transparency from mutual funds in the areas of holdings, expected returns and associated risks. For example, investors betting that the dollar will reverse its decline against the euro will benefit by diversifying their portfolio with funds investing in U.S. companies that derive revenues from Europe and, perhaps, Japan.

Also, as a whole generation gets closer to retirement, the risk appetite levels of many mutual fund investors will be shifting to opposite sides of the risk tolerance spectrum - those who have saved enough for retirement will look for low-cost, low-volatility "safe haven" investments; others will have to invest more aggressively to build up their nest eggs as quickly as possible. The former may be drawn to index-based ETFs, while the latter may pick individual stocks for their portfolios or make use of riskier hedge funds. Either way, mutual fund families can retain a large share of that market by introducing a new mix of products tailored to investors' changing risk requirements.

Finally, there is the issue of product inefficiencies, such as high management fees that can exceed 1.5 percent of assets, and high turnover, which may cause extra tax liability for investors without providing a comparable increase in returns. ETFs usually are effective solutions to both issues, but they often are viewed as less than optimal additions to many portfolios because they're usually tied to a broad market index; however, as ETFs offer more-focused investment options, they will threaten the dominance of mutual funds.

Adding Value to the Product

The developing new market landscape also has made it clear that mutual fund families will have to take decisive technological actions to keep their share of the market and sustain profitability. For example, the funds can leverage technology to determine expected risk and return of the asset pool using various financial modeling techniques, such as frontier and Monte Carlo simulations, and make the results available on their respective Web sites. Another option, especially for large fund families, is to significantly reduce the number of individual funds and create so-called "funds of funds" that are tailored to different investor risk demands.

The right use of technology can help reduce the costs of managing large portfolios of assets by taking some of the stock picking and guesswork out of the managers' hands and passing the savings on to investors. Fund families investing in information technology to enhance products and services gain a competitive advantage in a high-margin market segment that, so far, is surprisingly lacking in transparency, technology innovation and customer orientation.

About the Author

Eugene Gilerson is a product manager at a leading financial services firm and an IT strategy adviser for small- and medium-size businesses. He holds an MBA in finance and his business focus is on innovation in IT products, services and processes. Gilerson can be reached at [email protected].