Alternatives

A turbulent decade for fund industry started off well

The mutual fund industry, buffeted by volatile markets, unprecedented scandals and new competition, has had a tough time over the past 10 years.

The industry started off the decade looking good.

More than 130 U.S. mutual funds — a record — posted returns of 100% or more at the end of 1999. That compares with just six funds in 1998 and none in 1997, according to fund tracker Morningstar Inc. of Chicago.

It was a new day for the fund industry, and it was letting everyone know about it via advertising touting terrific returns, according to Don Phillips, a managing director at Morningstar.

“The industry started to believe it could do no wrong,” he said.

BUBBLE BURSTS

That belief, however, was shattered in March 2000 when the technology bubble burst and the markets came tumbling down.

The performance of once-high-flying mutual funds sank like a stone.

Investors in what were once “can’t lose” funds were faced with poor performance and in some cases massive capital gains taxes in 2000.

The capital gains poster child was the now-defunct Warburg Pincus Japan Small Company Fund, from Warburg Pincus Asset Management Inc. of New York.

It issued a 55% capital gains distribution in 2000 and ended the year down 71.8%. That was after posting a 329% return at the end of 1999.

Investor confidence in the fund industry was badly dinged, Mr. Phillips said.

Total net assets declined to $6.39 trillion at the end of 2002, from $6.85 trillion at the end of 1999.

Industry watchers, however, warned against assuming that the decline was due solely to bad feelings, because it correlated with what would eventually be identified as a prolonged bear -market.

The bear market may have hurt the industry bottom line, but it also forced the industry to get back to basics, said Jeff Tjornehoj, a Denver-based senior research analyst with Lipper Inc. of New York.

Fund companies stopped hyping performance and started to focus on the development of products that they wouldn’t have to feel sorry about later, he said.

“There used to be a feeling that fund companies would throw anything at the wall,” Mr. Tjornehoj said.

Fund companies instead started to focus more attention on the developments of relatively conservative products such as life cycle funds.

Such funds have proved to be a major boon for the fund industry.

At the end of last year, there was $238 billion in such funds, up from $34 billion at the end of 2002, according to the Investment Company Institute, a Washington-based mutual fund trade group.

The industry, however, would hit a major bump in the road Sept. 3, 2003, when then-New York Attorney General Eliot L. Spitzer said that he had “obtained evidence of widespread illegal trading schemes that potentially cost mutual fund shareholders billions of dollars annually.”

The Securities and Exchange Commission jumped into the fray Dec. 18 of that year, when it announced an enforcement action against Alliance Capital Management LP, accusing the New York firm of allowing illegal market timing of its funds.

Alliance quickly settled with the SEC, agreeing to pay $250 million in fines.

The SEC would eventually extract more than $3 billion in fines from fund advisers.

It would fine firms such as the now-defunct Pilgrim Baxter & Associates Ltd; Columbia Management Advisors Inc. and Columbia Funds Distributor Inc., both defunct subsidiaries of the former FleetBoston Financial Corp.; and Banc One Investment Advisors Corp., once a unit of the former Bank One Corp.

“That was a tough time for the industry,” said Richard Schroeder, executive vice president of Schroeder Braxton & Vogt Inc., an Amherst, N.Y., financial advisory firm with $220 million in assets.

It helped drive home the point that a fund group’s reputation is just as important as performance, he said.

Beyond fines, the SEC made sure that the implications of the market-timing scandals would be felt for years to come via a slew of new regulations.

Under the rules, fund boards are now required to adopt written compliance policies and procedures to prevent violations of the federal securities laws.

The rules also require asset managers and registered investment advisers to hire chief compliance officers to make certain that rules governing everything from personal trading by portfolio managers to adequate disclosure of conflicts of interest are followed strictly.

It is too early to tell what the lasting effect of the rules will be, but since 2003, the fund industry has remained relatively scandal-free.

It has also remained very profitable.

Total net assets increased to $12.02 trillion at the end of last year, from $7.41 trillion at year-end 2003.

In an attempt to ensure that assets continue to grow, the fund industry in recent years has launched a number of funds that use alternative, hedge-fund-like strategies that make even greater use of complicated vehicles such as derivatives.

To some extent, such strategies are being developed to ensure that the industry stays competitive as it battles hedge funds and separately managed accounts for assets, said Burton Greenwald, a Philadelphia-based mutual fund consultant.

It is a welcome trend, said Harold Evensky, president of Evensky & Katz Wealth Management in Coral Gables, Fla., whose firm oversees $600 million for clients.

He conceded, however, that the industry’s increased use of complicated derivatives products could lead to trouble down the road for investors who invest in them and firms that sell them.

Another area of innovation is exchange traded products.

Within the past couple of years, advisers have been able to buy exchange traded products that give them access to almost every segment of the market.

There were 629 such products — mostly in the form of exchange traded funds — with $608.42 billion of assets at the end of last year, up from 119 products with $150.98 billion in assets at the end of 2003, according to the ICI.

E-mail David Hoffman at [email protected].