Lipper Research Senior Analyst Don Cassidy on "Business for Breakfast" 1060 KRCN - Recent Trends

Tuesday, January 3, 2006

A. Sure. It has really not turned out to be a bad year at all for equityfund investors--not spectacular, but not hard either.

Q. Can you put some numbers around that?

A. Of course. There are 391 Colorado-managed funds and classes of fundQ. Don, it's a brand new year. Can we talk about some of the newer thingshappening in the funds world lately?

A. Sure. I think there are a number of recent trends worth mentioning:

• More fund companies putting on back-end redemption fees ofabout 2%
• Funds "on steroids" that give a multiplier of their underlyingmarket move
• Reverse, or inverse, bond funds
• Now over 200 exchange-traded funds (ETFs) to choose from, andthe variety is growing
• New ETFs that are based on things other than securities baskets/indices
• Funds adding to their net asset values via settlements from the trading scandal, boosting apparent "returns"
• Brokerage-firm funds changing their brand names
• Bear funds
• Option-writing funds
• Life-cycle funds--very popular

Q. Okay, let's take those one at a time... Why would funds be addingredemption fees?

A. It is a convenient way to make more money, while trying to reduceshareholder redemptions. It is part of the fallout from the tradingscandal, in which the funds are trying to cut down short-term trading byaggressive investor/traders. Of course, if the window is 365 days, that cancost some longer-term investors whose financial needs force a sale intopaying 2%.

Q. What can people do about it?

A. Not much to prevent it. But it bears asking some questions on the 800number, before buying any fund!

Q. What about those "souped-up" funds you mentioned?

A. They are not very numerous, and they typically use options or futures toincrease returns. For example, there is a fund that gives twice thepercentage move of the Japan market. It did great in 2005. But if peoplechase the hottest performers without investigating fully, they may notrealize they are buying a fund that will fall by a multiple when it falls.Not everyone has the intestinal fortitude for big volatility. So, again,the watchword is "do your homework!" Some brands that have several ofthese are Rydex, ProFunds, and Powershares, but they are not the only ones.

Q. What about these inverse bond funds?

A. A few--less than a handful--have come out in the past two to three years.They let individual investors make a bet that interest rates are going torise, since their value goes up if the price of longer government orcorporate bonds falls. They are pretty aggressive tools, but they doprovide a way to invest in accounts where you can't go short, as in an IRAaccount. They can let you hedge your bond and other income fund positions.Rydex and ProFunds are the leading brands.

Q. And you said there are now over 200 ETFs?

A. Right! The assets are very close to $300 billion, or about 4% of thetotal funds world. They started with major indices like the Spider for theS&P 500 and then expanded to single-country funds. Now we have a widevariety of indices--domestic and world--and a lot of industry and sectorfunds as well.

Q. ETFs have become popular because of what?

A. Their low expenses and the fact they trade all day, so the activeinvestor can use any kind of stock-type order rather than waiting for anunknown price after the close.

Q. And you say that some ETFs have gone beyond the original concept ofbeing based on a basket of stocks or bonds, or a stock index itself?

A. Right. There are two ETFs trading that represent one-tenth of an ounceof gold. The more-liquid one is GLD and the smaller is IAU. These are basedstrictly on the price of the commodity, not a basket of gold mining stocks!A few weeks ago ETF trading started in the price of the euro against thedollar. The ticker on that is FXE. So, you now have a traditional commodityand a currency in the ETF world. And ETFs on silver and oil prices havebeen proposed too.

Q. Getting back to funds, you said some settlements are coming in from thetrading scandal fines?

A. Yes. We thought the funds would make individual refunds to holders atthe account level. But in at least one case, Merrill Lynch Global Value,the advisor paid a settlement into the fund itself, which jumped the NAVand therefore performance late in 2005 by about 10%. The advisor did noteven specify exactly how much was paid, so Lipper put a footnote onperformance and will not consider the fund for a performance award.

Q. Do you think more funds will settle in 2006?

A. It has been a very slow process, but yes, some more will. The biggestshame, we think, is that some fund brands involved have not even been namedfor investigation. So, as time passes the case gets colder and some mightskate by.

Q. You mentioned brokerage-firm funds changing their brand names...

A. I suppose it is similar to brokerage firms getting out of the fundmanaging business altogether, like Citigroup's deal with Legg Mason. Butwe've seen a few brokerage firms that have money management arms announcingthey will "re-brand" their mutual funds. The latest big one is MerrillLynch. I don't see what this accomplishes...the prospectus will still say whothe advisor is. Or maybe they will change the advisor name too, to disguiseit. Other than trying to make the public think a broker is not selling thema house-brand fund, I don't see what it accomplishes.

Q. Okay, and what about bear funds?

A. A bunch of those were created in 2002 and 2003, playing on people's ideathat the bear market would continue--typical bad timing for new niche orspecialty funds! They give people a way to play a down market withoutactually personally shorting, which you can't do except in a marginaccount. While the market's gains in '04 and '05 were modest or average,these funds of course showed equivalent losses. So, don't chase hot ideaslate is the lesson there.

Q. And those option-writing funds...?

A. Right. A bunch of these have come to market since early 2004, promisingto provide extra income (which people love) and appealing to people who areimpatient for more return in a churning, mainly sideways market period.They buy stocks or ETFs and then write options against them. They are fineif the market goes nowhere. But if the market goes up they see their stockscalled away and their potential gains limited because they wrote theoptions for income. And if the market falls, the income slightly cuts thelosses, but they still have a declining NAV. Most of these funds areclosed-end in structure. It is not really a new idea, since there was anearlier generation of such back in the 1970s.

Q. And finally, what about life-cycle funds?

A. They are getting a lot of assets from people who do not want to beinvolved investors. They are good choices in 401(k) and similar plans forsuch people. The concept is that the fund is focused on your retirementdate and becomes more conservative over time as you age. So, you don't needto change funds, since the fund itself evolves in nature.

Q. What will be invented in the future, do you think?

A. Hard to be specific. Maybe ETFs based on actively managed funds. But wecan be confident that the corporate finance folks and the lawyers willalways be working on something they can call "new and improved."

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Don Cassidy is a Senior Research Analyst at Lipper specializing in fund flows, exchange-traded funds, (ETFs), closed-end funds, equity fund performance, and author of Trading on Volume (McGraw-HIll).