Source: 2011 Investment Company Fact Book, 51^st Edition, Investment Company Institute: www.ici.org/pdf/2011_factbook.pdf

The mutual fund industry's lifeblood is "net inflows" – new investment minus redemptions. Since June of 2007, an astonishing $428 billion of net funds have flowed out of domestic U.S. equity mutual funds. Even counting foreign equity funds, the mutual fund industry has had net equity outflows of $334 billion. You can track net flows here: http://ici.org/info/flows_data_2011.xls

Through mid-2011, most of the cash leaving equity funds went into bond funds, but now that trend also looks wobbly.  The industry's once-vast reservoir of money market fund assets has declined by $1.3 trillion from its peak in January of 2009, to $2.6 trillion currently.

Aside from assets and flows, the mutual fund industry has developed image problems with the U.S. public. 401(k) participants are upset by high costs and lack of choice. Wealthy investors are frustrated by tax impact, and mass-affluent investors are fleeing mutual funds for the customization and cachet of ETFs and separately managed accounts (SMAs).

So, what's right with mutual funds?

Mutual funds remain one of the great home-grown American industries. However, the industry made five strategic mistakes that have led directly to current problems and investor disenchantment. Whether or not the industry can fix these mistakes, you can help your clients understand and avoid them, while participating in the attractive qualities mutual funds continue to offer. In this article, we'll suggest how.

A Large, Important U.S. Industry

The mutual fund industry's growth from 1960 to 2007 produced two related historic waves.  One was the conversion of the American middle class from bank savers into investors.  The other was the growth of the financial advisory/planning profession, fueled by the fees mutual funds threw off as front-end commissions and "trails." Had there not been a vibrant mutual fund industry over a half century, there would not be nearly as many successful financial advisors in the U.S.

In the 1960s and 70s, the financial planning professional emerged from the synthesis of life insurance and mutual fund planning ideas and organizations. Led by a powerful trade group, the Investment Company Institute, the mutual fund industry set professional standards, lobbied for investors' rights, and disseminated best practices.  No other industry has poured as many resources into educating consumers about personal finance.  Along the way, the U.S. mutual fund industry invented the money market fund, index fund, turnkey retirement plan, and 529 plan.

At the end of 2010, mutual funds held 27% of U.S. stock market cap and 33% of the value of all outstanding municipal securities, according to the ICI. About 44% of all U.S. households (52 million) owned mutual funds, and the average holding per household was close to $100,000. Mutual funds held $4.7 trillion of IRA and defined contribution retirement plan assets, just over half of the U.S. total ($9.2 trillion).

Yet, despite this big "wallet share," mutual funds may be a low-growth industry for some time due to strategic mistakes the industry has made, with cumulative consequences. By being aware of these issues, you will be better prepared to discuss your clients' perceptions and help them benefit from all that is still right with mutual funds.

Mistake #1: Too Much the Same – In 2008, there were more than 3,000 diversified domestic equity mutual funds in the U.S. Yet only one, Forester Value, produced a positive total return for the year. The vast majority of diversified domestic equity funds followed the S&P 500 down, like lemmings, and finished 2008 near its 37.0% loss. This mass failure helped investors understand how many mutual fund managers were running portfolios to track stock market indexes, and how few were focusing on innovative strategies to protect capital. Since 2008, the mutual fund industry's most significant trend has been toward "funds of funds," which gained $134 billion in net inflow in 2010, according to the Investment Company Institute. By design, a funds of funds produce blended average performance, which probably will again track close to indexes in the next bear market.

What you can do: Emphasize to your clients that the mutual fund structure can accommodate innovative, risk-sensitive, and low-correlated investment strategies.  For example, a relatively new category of "market neutral" funds has emerged in the past few years. Although the category has produced debacles, a few market neutral funds have shown the potential to generate consistent returns with low exposure to the stock market's systematic risk. One of the largest, TFS Market Neutral (TFSMX) is the top-performer in Morningstar's Market Neutral category over the five-year period ending 8/31/11, with an annualized return of 6.51%, vs. 0.61% for the category. The fund's expense ratio of 2.50% is high, and its annual turnover of 380% makes it advisable to hold inside retirement plans.

A newer strategy within the market neutral category writes both put and call options to capture market volatility in up and down markets. The leader is Eaton Vance, which introduced Eaton Vance Parametric Option Absolute Strategy (EOAAX) in September of 2010. The fund has a relatively low expense ratio (1.75%) for this category, but its track record is still too new for meaningful evaluation.

Mistake #2: Too Expensive – Actively managed equity mutual funds are expensive to own, and they have became more so with the growth of C shares, which impose continuing trail (12b-1) commissions of .50% to 1.0%. According to an analysis conducted for the Wealthfront Blog by Lipper, Inc. in 2011, the arithmetic average expense ratio for actively managed equity mutual funds is 2.3%, as shown in the table below.

Total Costs for an Average Actively Managed Equity Fund

Source: Wealthfront Blog, 3/10/11; mutual fund cost study conducted by Lipper, Inc. and reported at: www.wealthfront.com/blog/actively-managed-mutual-fund-expenses

For the 10-year period ending 8/31/11, the annualized total return of the S&P 500 Index was 2.70%. So, the average equity mutual fund investor was left with less than a 1% net return per year, after costs. In recent years, most sales momentum in advisor-sold mutual funds has been in C shares and other "level-load" structures, as shown in the table below.

Net New Cash Flow by Share Class Structure (2006-10) All data in $billions

Source: 2011 Investment Company Fact Book, 51^st Edition, Investment Company Institute

C shares were designed to provide ongoing compensation to professional advisors in return for continuing advice, planning and service. But in the worst case, investors receive little or no continuing service and aren't even aware how much performance drag fund C shares impose.

In 2010, the SEC proposed limits on the cumulative fees that can be charged under mutual fund trails, and the proposal met fierce opposition from the mutual fund industry. The SEC has already adopted an exemption from Rule 22(d) that permits broker-dealers to eliminate mutual fund sales loads or create variations in sales loads at the account level. It seems likely regulators will adopt increased limits and disclosures on mutual fund shares with the highest cumulative costs of ownership over time.

What you can do: Add value by helping your clients assess the all-in costs of mutual fund ownership, and then tailor portfolios to client cost budgets. Adding low-cost index funds to a diversified portfolio can help to reduce costs without sacrificing performance. Also: Remind clients that mutual fund trails are a way of compensating you for continuing service. Make sure clients receive the service they pay for.

Mistake #3: Ignoring Tax Impact – About 58% of mutual fund assets are held outside tax-sheltered retirement plans and education savings accounts. Yet, the vast majority of mutual funds still do not have documented policies for managing tax impact. In a 10-year study covering the period 2000-09, Lipper found that the average U.S. equity mutual fund investor sacrificed .98% of return per year to taxes, and this represented 49% of the load-adjusted average total return in equity mutual funds over the decade.

The mutual fund industry's lack of tax-consciousness has created opportunity for more tax-efficient alternatives such as exchange-traded funds (ETFs) and separately managed accounts (SMAs). In the last year alone, U.S. ETFs have added $264 billion of assets and now exceed $1 trillion in total assets. Because ETFs and SMAs are held in brokerage accounts, tax cost basis information is easy to retrieve, store and analyze. In contrast, mutual fund tax support often is limited by paper-based legacy systems and inflexible share accounting methods.  For high-income investors, tax-inefficient mutual funds will become even less attractive when the new 3.8% Unearned Income Medicare Contributions Tax (UIMCT) takes effect in 2013.

What you can do:  Help clients purchase mutual fund shares (outside tax-advantaged accounts) through platforms that offer tax cost basis data, share accounting flexibility, and in-depth tax analysis. Also, become familiar with Morningstar's tax analysis metrics including: Potential Capital Gains Exposure, Tax Cost Ratio, and Tax-Adjusted Return.  More information on Morningstar tax analysis data is here: http://quicktake.morningstar.com/DataDefs/FundTotalReturns.html

Mistake #4: 401(k) Choices – One of the mutual fund industry's greatest innovations, the turnkey 401(k) plan, has become a double-edge sword.  As 401(k) participants have grown more cautious in investment outlook, complaints about high plan costs and limited investment choice are rising. Some participants feel "boxed in" by a narrow menu of mutual funds, with no attractive place to hide from stock market risk.

The mutual fund industry erred by trying too hard to protect its valuable 401(k) turf, and not trying hard enough to give 401(k) plan investors the same broad choices IRA investor enjoys – including low-cost investment options. The mutual fund industry also lost goodwill by promoting target date and lifecycle funds as default investment choice in 401(k) plans. In2007 and 2008, hundreds of thousands of novice investors were automatically enrolled in stock-heavy funds right before a historic market downturn. Their first investment experience left an indelibly negative impression. The mutual fund industry spent virtually no effort promoting the common-sense idea that first-time investors should wade into the stock market gradually, with low risk exposure, and learn as they go.

What you can do: For clients who are unhappy with investment choices in turnkey mutual fund plans, explore other options for building savings on a conservative base, with tax advantages. They include permanent life insurance, personal IRAs, and municipal bonds.  Older plan participants may be eligible in-service transfers from 401(k)s to Traditional IRAs, even while they keep working and participating in employer 401(k) matching contributions.

Mistake #5: Downscale Perceptions – Over the past decade, mutual funds have been out-flanked by ETFs and SMAs in the most lucrative market segments – mass-affluent and high net worth. This has left investors in these segments with the perception that mutual funds are a downscale, middle-market product.  The table below shows that the average mutual fund investor is five years older than the average ETF investor yet has meaningfully less income and assets.

Source: 2011 Investment Company Fact Book, 51^st Edition, Investment Company Institute

Part of mutual funds' middle-market reputation is due to their pooled fund structure. Unlike ETFs and SMAs, mutual fund assets are not held in individual client name, and portfolio transparency is limited.  Although these issues have become meaningful in the post-Madoff era, they are not necessarily a factor in moving mutual funds downscale. Hedge funds also have a pooled fund structure and limited transparency – yet they have continued to attract assets from the wealthiest investors.

What you can do: Emphasize that mutual funds are one option for accessing professional money management and portfolio diversification. They can be purchased on consolidated reporting platforms and combined into asset allocated portfolios with other structures including ETFs, closed-end funds, individual stocks and hedge funds. The days when most affluent or wealthy investors placed all their money with one or two mutual fund groups are over. But the vast number of good choices offered by the mutual fund industry should not be ignored. The best professional financial advisors will help clients methodically evaluate hundreds of mutual funds, to find the few that meet personal criteria and blend well with other portfolio assets.

In summary: Although the era of torrid growth may be over, mutual funds remain a large and important U.S. industry with a long tradition and many strong companies and money managers. The mutual fund industry has helped three generations of financial professionals earn a good living, and it will continue to support you in the future. Although the industry can't erase past mistakes, you can help your clients take advantage of the best qualities of mutual funds still have to offer.