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Who can blame them, considering the sorry record of most fund managers? With less than 20% of active managers outperforming the market, it is understandable that last year, for the first time ever, asset growth in individual stocks outpaced that of funds at discount broker and fund supermarket Charles Schwab. Or that No. 1 Fidelity has been stepping up promotion of its brokerage services, as more customers have looked to open hybrid portfolios made up of stocks and funds. "This industry has grown so rapidly that there is a shortage of good managers," says Bridget Macaskill, CEO of Oppenheimer Funds. "But mutual funds are fundamentally a good tool for small investors."
The fund industry is praying that the online trading boom and focus on just a few stocks (America Online, Amazon, eBay, Yahoo, Cisco) is a short-term phenomenon, the sign of a cyclical market that has got out of hand, rather than a fundamental, long-term shift. "It's based on a false sense of empowerment," claims funds watcher Avi Nachmany of Strategic Insight. Once the narrow bull market calms down, or broadens to include harder-to-choose value and small-cap stocks (as it appears to have done of late), Nachmany and others argue, investors will rush back to the relative safety of a diversified mutual fund. "Investors have abandoned the risk side of the equation, but it's not sustainable," says Greg Johnson, president of Franklin Templeton Distributors, a $155 billion fund family that has lost $7 billion of cash this year as investors fled its faltering value and international funds. "There are more than 10 good ideas for investing."
Unfortunately for the industry, one of the most popular ideas, at least for now, is to have practically no manager at all. Nearly one out of every five new investment dollars is now going into low-cost index funds, which automatically mirror the performance of benchmarks like the Standard & Poor's 500. Already this year $18 billion has flooded into Vanguard, the behemoth that pioneered the practice. Says John Rekenthaler of funds researcher Morningstar. "Indexing is an ongoing challenge that most of the competition is not facing up to."
It's no surprise, then, that much of the competition isn't faring too well either. Close to half the 600 or so mutual fund families experienced net withdrawals in the first quarter of 1999, and floundering funds were merged out of existence at a record pace last year, according to Lipper Inc. Once-high-flying firms such as Stein Roe, Pilgrim Baxter and Berger Associates are reassigning dud managers and hustling to attract new money. Says Stephen Cone, president of customer marketing at Fidelity Investments. "We're not going to see the phenomenal growth of the past, and that may be an alarm bell for smaller firms. Their jobs have got much harder."
They may soon have no jobs at all. Some observers think that within a decade, more than half the 600 fund companies could disappear, as outfits with less than $50 billion in assets become ripe for the picking. With the big boys dominating the highly profitable institutional side of the business--401(k)s and other retirement plans--and much of the growth now coming from market appreciation, it will be hard for a second-tier player to shine.