A look into the fund industry crystal ball

Your Funds

Dollars & Sense

January 12, 2003|By CHARLES JAFFE

EACH YEAR at this time, I attempt to forecast the big developments for the fund industry in the coming 12 months. Since I started doing this in 1995, I've gotten about five calls right for every seven I've made, missing one forecast by making it too early and another for being flat-out wrong.

I long ago stopped forecasting the stock market. But I'm not afraid to predict that fund investors will see the following things over the next 12 months:

Sharply reduced returns for bond funds. It was an exceptional year for bond funds in 2002, with interest rates reaching historic lows that pushed these funds to high performance.

Rates could stand still for months. But when interest rates rise - which I suspect will be in the second half of 2003 - bond funds will suffer. The result will be gains in line with a fund's "30-day yield," a measure that reflects the payout that the fund gets from the bonds in its portfolio. In 2002, many bond funds earned more than double their 30-day yield.

A push for disclosure of fund manager pay. Once the Securities and Exchange Commission finishes requiring funds to disclose their full portfolio every quarter and to say how they voted on proxy issues of stocks they own, the next disclosure it is likely to consider involves manager pay.

Before 2003 is over, I suspect, a few funds - most likely part of the social investment realm - voluntarily will reveal the incentives they use to spur management to produce performance. The incentives show how a manager is likely to act. If the bonus is based on after-tax returns, for example, the manager will strive for tax efficiency.

The public will call for actual salaries. The regulatory compromise - which I don't expect to see enacted until 2004 - will be disclosing compensation incentives somewhere deep in the prospectus.

Expense ratios rising. Fund companies have tried to hold the line on costs through much of the market downturn. After three years of dwindling profits because of declining markets and greatly reduced inflows into funds, the firms will step up the fee increases in an attempt to maintain their profit margin. By the end of 2003, the average stock fund will have an expense ratio north of 1.5 percent, up more than 0.1 percent from 2002.

Fund consolidation mania. There is no better way for a fund company to bury a miserable track record than to merge its stinkiest funds right out of existence. If the market turns in 2003, it provides the perfect opportunity for firms to profit. They'll create new funds similar to older offerings, then kill off their existing track records by merging the old funds into the new, preferably right after the market has given the new fund a boost.

No progress on mutual fund shareholder tax relief. There is a proposal in Washington that, if passed, would make the capital gains a fund distributes to shareholders exempt from taxes (up to $3,000 in gains per person per year would be tax free). With Congress focused on President Bush's plan to change the capital gains tax, and with few investors crying over taxes paid on the gains racked up by their funds (because there were so few funds actually paying out gains), this issue has fallen to the back burner. It won't heat up in 2003.

More freedom for fund managers. In recent years, fund firms frequently handcuffed managers by limiting them to a specific area of the market, such as small-cap value stocks. When managers find attractive stocks outside of that basic group of interest, they often pass, sticking to their perceived charter even if it means letting a good prospective investment go.

Anxious to post decent numbers, some firms will ease restrictions on managers or create new "go anywhere" offerings - all very similar to the old days of fund investing, when a legend like Peter Lynch could invest in whatever piqued his curiosity - in the hope that investment creativity will be rewarded.

Gimmick funds preying upon fear. In the bull market, tricky new funds focused on greed, investing in niche markets such as the Internet. In the bear market, funds with insurance kickers and other costly ways to protect investors have gradually become more common. In 2003, they'll become a full-blown epidemic; as with the Internet funds that blossomed after 1999, the ultra-defensive gimmick funds of 2003 won't be worth owning for long.

Charles A. Jaffe is mutual funds columnist at The Boston Globe. He canbe reached by e-mail at jaffe@globe.com or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.

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