Mutual funds face competition from ETFs, VAs and others

The combined total launches last year of exchange traded funds, variable annuities and closed-end funds surpassed open-end mutual fund launches for the first time, according to Boston-based research firm Cerulli Associates Inc.

Of the 820 fund launches in 2007, 47.2% were open-end mutual funds. That share fell behind the combined total of ETFs, with 34.8% of new launches, variable annuity products, with 13.2%, and closed-end funds, with 4.9%

“The bottom line is that it’s not just about the [Investment Company Act] mutual fund anymore,” said Cindy Zarker, director of U.S. retail asset management at Cerulli. “There are a lot of different products competing for wallet share.”

The study also looked at equity mutual funds and found that funds that do not fit into traditional Morningstar style boxes, or categories, such as funds that include alternative investments or target date funds, have been gaining market share for the past five years, while conventional funds have lost share. Morningstar Inc. is based in Chicago.

The market share of assets for equity mutual funds that fit into style boxes dropped to 72.8% in 2007, from 78.3% in 2002, the year it started to decline. At the same time, funds that do not fit into style boxes gained market share to 27.2% in 2007, from 21.7% in 2002, the year it started to increase. In 2006, the market share of assets for equity mutual fund that fit into style boxes was 74.2% and 25.8% for funds that did not fit into style boxes.

The Cerulli study included a survey and interviews with more than 50 asset managers.

“The whole product landscape has changed, Ms. Zarker said.

“Many of the asset managers are concerned that target date funds could take assets away from the mid-cap- or large-cap-value funds where investors have traditionally made long-term investments,” she said.

Of the asset managers surveyed, 57.9% saw target date and risk-based funds as a significant threat to single-asset-class funds in retirement plans, and 31.6% defined them as somewhat of a threat.

While mutual funds continue to dominate in assets, their growth rate is trailing that of ETFs.

According to Boston-based Financial Research Corp., the five-year compound annual growth rate for mutual funds was 16% through April, compared with 33% for ETFs, 16% for separately managed accounts and 9% for variable annuities. Assets in mutual funds totaled $7.6 trillion as of April 30, FRC reported, compared with $601 billion for ETFs and $1.3 trillion for variable products.

Advisers are not surprised.

“The tax efficiency is huge for ETFs, relative to the use of the traditional mutual fund,” said Carolyn McClanahan, founder of Life Planning Partners Inc. of Jacksonville, Fla., which has $25 million in assets under management. “We are leaning to using more ETFs for tax efficiency.”

Variable annuities are also gaining ground, because of guaranteed income. “People who have not used variable annuities are starting to take a harder look,” Ms. McClanahan said. “There is a role for them as part of a portfolio, but not the whole portfolio.”

There will always be room for mutual funds, said David Greene, a vice president of CJM Wealth Advisers Ltd. of Fairfax, Va., which manages $400 million in assets.

But ETFs and other products meet other needs.

“It’s just more arrows in the quiver,” Mr. Greene said. “Advisers can be more selective on which products fit the client better. There could be a downside. More products mean more choice, and more choice can be confusing.”

Expense is not a reason to rule out variable annuities, said Ivory Johnson, director of financial planning for Scarborough Capital Management Inc. of Annapolis, Md., which has $1 billion in assets under management.

“Variable annuities have protection and are popular even though they are more expensive than mutual funds,” he said. “There is no guarantee with mutual funds.”

ETFs have a lower expense ratio and allow investors to specialize, Mr. Johnson said.

The wave of alternative investments is likely to continue, he said.

“Studies have shown that alternative assets reduce risk and in-crease your return,” Mr. Johnson said.

“There is a higher interest among investors in alternative investments,” Ms. McClanahan said. “But their fees tend to be higher, and you have to look under the hood harder to see what your clients are getting into. The important thing for advisers is to choose what they feel comfortable using. Know what you know, and know what you don’t know.”

More-complex products are on the rise, Ms. Zarker said. The successful firms, she said, will work to educate advisers on how to use the products.

The industry will continue to create sophisticated investments, Mr. Johnson said. “This is their DVD player in the back seat of the Tahoe,” he said. “That’s why you’ll always have advisers.”

E-mail Sue Asci at [email protected].

Related Topics: E*Trade Financial Corp.