Fund Companies Rediscover Diversification

It’s been more than a year since the bear market ended, yet its effects are still percolating through the fund industry. It can be argued that the market slump at the beginning of this decade has forced just as many industrywide changes as the market-timing scandal. Increasingly, I’m seeing fund companies that have completely overhauled their message. And most of them have gotten religion about diversification.

In the 1990s, many fund companies talked out of both sides of their mouths. On the one hand, these shops may have had a diversified fund lineup and provided educational materials preaching the benefits of spreading your bets around. But at the same time, their sales forces were out there pushing their hottest-performing funds--hard.

Naturally, this meant that a fund company was selling $10 of its most aggressive growth fund for every $1 in its most conservative value fund. It’s easy to see why. Fund wholesalers were being paid based on the amount of sales rather than the success of clients, and it was far easier to sell the fund that was up 60% than the one that was up 7%. This meant many investors were set up for a big fall when the bubble burst, and they were none too happy with the fund companies whose funds blew up on them.

This was especially true at companies like AllianceBernstein, Putnam, and AIM, which were best known for their growth funds. These were the shops that suffered outflows even before the market-timing scandal raised questions about their operations. Now they and others have embraced the new religion of diversification. While there can be a short-term disconnect between a fund company’s sales and a client’s success, over the long haul they’re much more closely tied. Realizing this link, these shops are now making a much greater effort to ensure that investors use their funds properly.

If you go to most broker-sold fund company Web sites, you’ll see a greater emphasis on plans for diversification. Some fund companies are pitching complete solutions in a single fund that invests in a bunch of other funds (or their portfolios). For example, AIM has three allocation portfolios. Putnam has its own group of asset allocation portfolios that invest in multiple portfolios rather than funds. True, they existed before the bear market, but few people owned them while huge numbers of unfortunate folks owned Putnam’s growth funds. Other firms instead have packaged a number of funds together in set proportions.

To find out if the fund companies really mean business or are just talking a good game, you have to look at the way they pay bonuses. In the mutual fund world, bonuses often come in multiples of salaries, so it’s hard to overstate their importance, for both fund-company personnel and investors. To give you some sense of their significance, picture this: Fund company salespeople are hungry lions with a taste for zebra. The stuff that fund companies say is important publicly without actually meaning it is a boulder with a zebra painted on it. Picture the bonuses, where the real priorities are buried, as a young fat zebra that’s just injured its hoof and is unable to run very quickly. Given their choice of prey, do you think the lions' heads are going to be turned by the stripes on that boulder?

Fund companies are telling us that they’re overhauling their sales incentives to emphasize diversification and time spent with clients, rather than dollar volume of sales. This tells me they mean business. The new priorities should result in investors getting a more sober message about a building a plan that works for them. If the effort succeeds and people end up with well-rounded portfolios, the fund industry will be much closer to fulfilling its potential.

This isn’t the whole battle, of course. Many fund companies, including those I’ve mentioned, also need to do a much better job of managing money. It’s a work in progress on both fronts.

The catch is that if you want great performance, you might not want an all-in-one fund from some of these companies. Only a handful of fund families are strong enough across the board to offer a fund of funds that you'd really want as a total solution. Vanguard, Fidelity, and T. Rowe Price come to mind, but there aren't a lot of others.