Despite recent market volatility, US investors' fondness for mutual funds looks set to continue. with trends in pensions investment set to fuel further growth, reports Duncan Hughes

AMERICAN investors' long-running love affair with mutual funds has survived the recent strains caused by extreme market volatility and appears to be as strong as ever.

US bluechips and smaller stocks teetered on the edge of a bear market during the summer before successive interest rate cuts triggered a rebound. The big fear was that a crisis on Wall Street would trigger a meltdown on Main Streets" across the US causing small investors to be stampeded into panic selling of their holdings.

While some investors used the volatile conditions to restructure their portfolios there was little evidence of forced selling. Only 14 of the funds that invest in US stocks made money during the third quarter, according to financial publisher Morningstar, with the average domestic equity fund dropping 13% of its value. Things were worse for investors with exposure to overseas markets. The average emerging markets stock fund has lost half its value during the past year with several fund management companies saying they will liquidate their portfolios.

According to the Investment Company Institute, the national association of investment companies, it takes a protracted downturn for US investors to consider sustained redemptions of their holdings. About 66m Americans own mutual shares in either investment funds or through employer-sponsored retirement plans. That means more than one-in-three households have a stake in one of the 3,415 stock mutual funds, 2,257 bond funds, 520 hybrid funds and 1,016 money market funds. The institute estimates there is about $5trn in assets held in the funds - that's more than the current annual gross domestic product of Japan. Of this, nearly half is held in stock funds with the remainder spread over fixed interest, cash and hybrid funds.

Through to August this year, about $135bn was invested in stock funds with about $9 out of every $10 flowing into the US stockmarkets. The typical mutual fund investor owns three different stock funds with more than half also holding bond and income funds. US investors' appetite for foreign markets has been spoiled by the Asian economic crisis, the collapse of Russia and fears that it might spread to Latin American markets. A spokesman for the institute said: "Stock fund shareholders typically are experienced investors with a long-term orientation." A study of investor habits during the 50 years to the end of 1995 found that investors generally keep their cool during bear markets. The biggest outflow followed the October 1987 crash when an estimated 4.7% of total assets were redeemed.

A seven-year bull run - the longest in US history - has encouraged a new generation into the markets. Institute president Matthew Fink says: "Some allege that when the market has its next major break, mutual fund shareholders will panic and redeem in droves, forcing portfolio managers to dump securities, pushing stock prices down even further, and causing a 'run' on funds similar to bank runs. "I believe that fund shareholders will behave as they have in other market breaks: they will not engage in panic redemptions, but they will lessen their new purchases of fund shares." Geoffrey Bobroft, the president of mutual fund consultancy Bobroft Consulting, says the industry is next likely to see pressures on its liquidity around 2007-10 when the 'baby boomers' start redeeming their holdings for retirement income. Bobroft says: "There is nothing currently on the horizon that will materially effect the tone or trend of the US mutual fund industry. There is no alternative for the forseeable future, barring a calamity it will prosper, and prosper quite healthily."

The money flowing into the industry comes from a number of sources. According to the US Federal Reserve, households have been net sellers of district holdings of individual stocks while acquiring mutual fund shares. For example, in 1997 households sold $472bn worth of individual stocks and bought $185bn of equities through stock funds.

While the strength of the US economy and stockmarket has fuelled investor enthusiasm, the increasing tendency for employers to switch from defined benefit to defined contribution pension schemes is also contributing to rising volumes under management. The retirement share of mutual fund assets was about 35% for the fourth consecutive year in 1997 (the latest available statistics). Bobroft believes there are parallels between the US pension experience and what he sees emerging in Europe: "A clear positive for the European markets is the success it is having with packaging defined contribution schemes."

Britain, for example, has more than a decade's experience in weaning people off the state or company defined benefit package and toward provision of mutual fund-based defined contribution schemes. But in other European countries, such as Germany, the transition is still in its comparative infancy. "The US model has worked well. Europe should take note of the US process, which has embraced mutual funds rather than some other form of collective scheme." Mutual funds' share of the $7.5trn US employer-sponsored pension market rose to 10% during 1997, up from 9.5% the previous year. Mutual fund assets held by employer-sponsored plans increased 27% to $774bn.

For individual retirement plans, mutual fund assets rose 28% to $822bn during 1997 as a result of strong investment performance and rollovers from employer-sponsored pension plans. Fink says: "Over 35% of all mutual fund assets are held by retirement plans of various types. Overall, mutual funds hold about one-fifth of all US retirement assets. Mutual funds have opened the securities markets to millions of Americans."

Michael Lipper, chairman of Lipper Analytical Services, the mutual fund performance analysis company, believes the development of the European pension market is "similar but not identical" to the US situation. He believes differences in taxation and European governments' temptation to impose complex regulatory regimes could hinder growth. "Involuntary pension_scheme owners who claim they were misled will provide a strong position for politicians to bring on a different and more rigorous regime. While I know of no problem in Europe, the lack of a self-regulatory regime means that it will be more reliant on government regulations, which tends to become a bit of a problem later."

Lipper is not opposed to regulation but believes excessive meddling by authorities distorts market performance. He believes the growth of this pension market will probably strengthen the equity movement in many quarters and will provide a broadening of the market so increased privatisation will be possible. Mutual fund inroads into the pension market have triggered a large number of mergers and acquisitions among fund management companies.

But Fink says: "The evidence is that the industry has grown less concentrated over time." In 1990, the five largest fund organisations held 36% of all industry assets. Seven years later the five largest funds' holdings had dipped to 34%. Similarly, assets of long-term stock and bond funds have also avoided becoming more concentrated in larger fund organisations during the decade. The percentage of long-term assets held by the five largest fund management companies was unchanged between 1990 and 1997.

Fink attributes the diversification to very few acquisitions or mergers having involved sizeable fund organisations. Also, the development of new distribution channels has enabled smaller, high-performance funds to develop. The absence of a truly national US bank and insurance companies' reluctance to embrace mutual funds has provided marketing opportunities for new operations.

Says Bobcroft: "In the US distribution has been multifaceted but Europe is different. I do not know whether it will end up with one or more distribution channels." He contrasts the bank domination of the sector in Germany with the brokers' marketing strength in the UK.

Lipper believes that cultural and language differences will slow the development of pan-European development channels. Most funds in Europe are sold on a "face-to-face basis", he says, and the most successful face is likely to be that of a fellow national. "In reality, Europe does not exist. It is individual countries, individual markets and individual patterns." But he expects the US industry to have a significant impact on the way mutual funds are both sold and managed. "In Europe we are likely to see better definition of each, leading to a more competitive and focused sector. All of this will evolve and evolve differently from what we expected. But they tend to evolve after a period of down markets and at some time we will have them."

Duncan Hughes is a freelance journalist"