All Business

BEWARE FUNDS BEARING GIFTS

The mutual fund industry is sorry, But you shouldn't forgive and forget.

STEVE MAICH December 13 2004
All Business

BEWARE FUNDS BEARING GIFTS

The mutual fund industry is sorry, But you shouldn't forgive and forget.

STEVE MAICH December 13 2004

BEWARE FUNDS BEARING GIFTS

The mutual fund industry is sorry, But you shouldn't forgive and forget.

All Business

STEVE MAICH

RESEARCHERS have known since the 1960s that the ability of rat colonies to coexist peacefully is directly correlated to the availability of food. As long as garbage is plentiful, rats will live side by side, more or less content to ignore their rivals as they gorge themselves. But when supplies begin to dwindle, rats turn on each other to establish dominance and survive. In rare circumstances, they’ll even resort to cannibalism.

This behaviour has strong parallels in the human world—and, it turns out, the mutual fund industry as well. When everybody is getting fat and rich together, we all get along.

But when times turn tough, it doesn’t take long for the big rat next to you to start eyeing your dinner. That’s exactly what is happening now in the mutual fund business.

Fund companies won’t like being compared to vermin. They devote inordinate amounts of energy and money to presenting themselves as insightful, trustworthy and honourable institutions—attributes not typically associated with rats. The comparison isn’t intended as a slight; I mean no disrespect to mutual funds (or to rats, for that matter). It’s just that certain laws of nature have begun to assert themselves in the industry. Too many funds are chasing a dwindling supply of dollars from an increasingly demanding and educated consumer. The days of getting fat together are over.

This point was driven home late last month when Fidelity Investments, the Canadian arm of the U.S. fund giant, disrupted the tranquil harmony among the mutual fund companies by announcing an eight per cent cut to the management fees it

charges clients. If you have a fund that used to charge 2.5 6 per cent a year, that will now be 2.36 per cent. It may not sound like a big deal, but the change will cost Fidelity about $25 million a year in revenue, and will directly benefit fund holders through higher returns. Analysts expect other firms will have to follow suit, raising the spectre of the first-ever mutual-fund price war.

Investor advocates, who’ve long griped about high fund fees, are understandably delighted by Fidelity’s initiative. It’s worth remembering, however, that this is a defensive move, born out of a mounting sense of

desperation in the industry. Fidelity’s fee cut is not about generosity, it’s about ensuring long-term survival. And it shows just how far the fund sector has fallen, and how fast.

Widespread fee reductions would have been inconceivable in the late 1990s, when consumers’ appetite for funds seemed insatiable. Hundreds of firms sucked in mountains of cash from fledgling investors looking for an easy way to join the bull-market party. And what a party it was. And what a hangover it has produced.

Last year was the worst on record for the mutual fund industry. For the first time in 15 years, fund companies paid out more in redemptions than they collected through sales—this despite a strong rebound in the stock markets. In all, investors cashed out

FIDELITY’S fee cut is not about generosity, it’s about ensuring survival. And it shows just how far the fund industry has fallen, and how fast.

$607 million and closed more than two million fund accounts. Sales have rebounded somewhat this year, outpacing redemptions by $13.5 billion through November. But that’s still a far cry from the feast of 1997 and 1998, when fund firms could pull in that much new money in just a few months.

Fidelity has been one of the hardest-hit by the downturn. For eight straight months, customers have cashed out more funds than the company sold. In the past three months alone, Fidelity saw $705 million pulled from its funds, and since December 2001, its assets under management have plunged

by $2.2 billion. The worst may be yet to come. In the late ’90s, Fidelity and others sold rafts of mutual funds with deferred sales charges—essentially, penalties for cashing out funds within seven years of purchase. Now, there is widespread fear that the companies will face a flood of redemptions as funds sold in the late ’90s reach their seven-year anniversaries and investors disappointed by their returns opt to get out. Clearly it’s high time for Fidelity and the rest to make nice with clients, and that’s where the fee cut comes in.

But the industry’s problems are wide and deep, and will not be smoothed away by price cuts and clever marketing. Mutual fund firms are still getting humbled by headlines about trading abuses and unethical management. Then there’s the issue of their chronically poor performance. Last year the benchmark Canadian stock index rose about 25 per cent, but the index of Canadian equity mutual funds, maintained by industry research firm Morningstar, climbed just 19.5 per cent, continuing a long streak of funds failing to keep pace with the market.

And while fund companies like to boast that they offer expert financial management for a bargain price, the numbers suggest many managers are neither expert nor a bargain. In fact, a recent study found that the more you pay in management fees,

the worse your funds are likely to perform.

All that has left small investors angry and looking for alternatives. Much of the money that used to fatten profits at firms like Fidelity, Investors Group and AIM Trimark now goes to income trusts, hedge funds, real estate and low-cost exchange-traded index units. And while Fidelity’s fee cuts are a welcome step, it’s not clear whether the industry really understands how its feast turned into a famine. It’s not just high prices that are turning people off. It’s the quality of the product.

Read Steve Maich’s weblog, “All Business," at www.macleans.ca/allbusiness