Hedge Funds Will Never Outgrow This Hulking Beast

Date: Tuesday, December 13, 2005
Author: Chet Currier - Bloomberg.com

Dec. 13 (Bloomberg) -- Quick now, which investment vehicle is growing fastest here in the mid-'00s? a) hedge funds; b) exchange-traded funds; c) mutual funds.

Answer: c) mutual funds, hands down. And no, that's not a trick question. While hedge funds and ETFs get all the plaudits as hot growth properties, neither is gaining any ground on the much bigger, supposedly mature mutual-fund business. If anything, they are falling farther behind.

Consider that at mid-2005, as the Investment Company Institute trade association recently reported, worldwide assets of mutual funds came to $16.4 trillion, up from $14.5 trillion at the end of the second quarter a year earlier.

That $1.9 trillion increase is more than the total assets of hedge funds ($1.1 trillion, according to Hedge Fund Research Inc.) and ETFs ($360 billion, according to Morgan Stanley) combined.

In the previous 12 months, from mid-2003 through mid-2004, worldwide mutual fund assets grew $2.1 trillion. All this happened while mutual funds were struggling out from under the ugliest scandal in their 80-year history.

Now, I acknowledge that hedge funds may have been growing faster in percentage terms. But if I turn $20 into $40, doubling my money, while you increase your $200 to $240, for a mere 20 percent gain, I wind up further behind you in total wealth than I was before.

To overtake you, I will need to keep growing faster in the same percentage terms year after year for, oh, about another 3 1/2 years. The bigger the base, the harder those doubles will be to achieve.

Handicap

The stereotypical hedge fund relies on pure skill to distinguish itself, rather than riding the currents of rising stock prices and the flow of dividends from stocks and interest payments from bonds. Most mutual funds, being ``long only'' investors, have these tides on their side.

In other words, if hedge funds are ever going to catch up with mutual funds, they will have to overcome an enormous natural disadvantage to do it. All in all, an unlikely prospect.

Theoretically, at least, mutuals' natural edge would turn into a handicap if the tide were to reverse, if market returns on stocks and bonds turned negative for a sustained period. Well, yes, but how long could any investment vehicle prosper -- even those go-anywhere, do-anything hedge funds -- in an environment of relentless financial-market weakness? Sooner or later, a bad storm sinks all boats.

Retirement Plans

As if all that weren't enough to guarantee their continuing dominance, mutual funds are ideally suited for use in employer- sponsored retirement plans such as 401(k)s in the United States. One prime attribute of ETFs, continuous trading throughout the day, is of little value in 401(k)s. Hedge funds, with their sophisticated style and image, simply aren't compatible with the 401(k) format.

Why should an individual investor care about all this? It strikes me as a matter of keen interest, for what it has to tell us about the enduring strength of mutual funds as an investment vessel. It also speaks eloquently about the problem that is most likely to bedevil mutual funds in the years ahead.

A single fund group, Capital Group Cos.' American Funds, increased the assets in its stock and bond funds by $142 billion from mid-2004 through mid-2005, according to my calculations from data published by consultants Financial Research Corp.

Capital and the other two industry giants, Vanguard Group and Fidelity Investments, together command $2.2 trillion in their stock and bond funds alone, according to FRC data.

Huge size, a great testament to success, can also be an albatross when you're managing money. In many types of investments, ranging from small stocks to high-yield bonds, it tends to hurt your maneuverability and severely cramp your style.

Comedown

A classic story of the rise and fall of a mutual fund can be seen at Fidelity's Magellan Fund, once the industry's biggest success story. From a peak of $110 billion in August 2000, its assets have tumbled to $50.7 billion at last report, and respected manager Bob Stansky has departed, turning over the helm to Harry Lange.

This sort of size trap threatens to ensnare more and more of the fund industry as its growth continues. The industry's long-term future will quite probably depend, more than any other issue, on how it deals with that problem.

Strange thought, isn't it? About the only thing that might ever push mutual funds off the top of Money Management Mountain would be their own ever-increasing size.

To contact the writer of this column:
Chet Currier in New York at  ccurrier@bloomberg.net.