An Uneasy Rebound for Fund Companies

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The prospect of a weaker U.S. dollar makes Franklin Resources a good bet, since it is one of the companies with the most leverage to a weakening greenback, Credit Suisse said. Non-U.S. clients generate 24% of its assets under management, but Franklin has said that over 90% of its operating income is U.S. dollar-based.

Much of Janus's estimated 23% asset-weighted return in the second quarter has come from its foreign-asset funds such as the Orion Fund and the Contrarian Fund, Credit Suisse said. Waddell & Reed's returns so far in the second quarter have benefited from the firm's Global Natural Resources Fund, which has returned 42% since Apr. 1.

ETFs: lower fees, better tax impact

Eaton Vance (EV) merits an outperform rating from Credit Suisse, in part because of how much its tax-advantaged strategies have contributed to its 8.8% asset-weighted return since Apr. 30.

The recent rally has helped restore some confidence in actively managed mutual funds, but the asset managers that run them face big challenges down the road. Growing awareness among retail investors about how much they are giving up in fees to mutual fund managers is boosting demand for exchange-traded funds, which have much lower fees and a more favorable tax impact from capital gains distributions.

BlackRock, with its $13.5 billion acquisition, announced on June 16, of Barclays Global Investors, Barclays' investment unit, will become the world's biggest money manager. That could speed adoption of ETFs by other asset managers if they see themselves as losing ground to BlackRock. ETFs have been aggressively gaining market share for the past 10 years and the general underperformance of actively managed funds with respect to indexes last year only added to ETFs' popularity.

A key challenge for actively managed funds in the future will be responding to competition from ETFs within defined benefit plans. Sponsors of 401(k) plans are already under pressure from Congress to improve their reporting to plan participants of performance, expense ratios, and fees for funds within retirement plans.

ETFs will force mutual fund fee cuts

"I believe eventually ETFs will find their way into 401(k)s," says Tom Lydon, editor of the Web site ETFTrends.com. He estimates that 401(k) plan participants would save 1% of their portfolios' value by investing in low-cost ETFs instead of actively traded funds. And because ETFs as a category are well-diversified—investing more than 50% of their assets outside the U.S.—they would better serve participants in 401(k) plans, given the expectations for speedier recoveries from the recession by some foreign economies and their larger future growth prospects, he says. The average 401(k) plan has about 12% of its assets allocated outside the U.S., he says.

Over time, competition from ETFs will put more pressure on mutual fund fees, says Fannon at Jefferies. To date, ETF growth hasn't come at the expense of mutual funds because there's been enough growth for all asset managers, But given the fact that mutual funds charge fees more than double the average fee ETFs charge, "there is room for fees to come down within mutual funds" without doing serious damage to mutual funds' operating margins, he adds.

Vanguard offers a selection of ETFs while Pimco, a unit of Allianz (AZ), has launched one that holds short-term Treasury bonds and Charles Schwab (SCHW) has a handful in registration that are likely to be rolled out by the end of this year, says Lowry. He predicts T. Rowe Price will offer ETFs in the future as demand picks up and says the firm is already structured to develop them internally.

As ETFs take advantage of a wider array of distribution channels—from high net worth investors to certain broker-dealer networks—they're likely to take more market share, although it remains to be seen how that evolves, says Fannon at Jefferies.

Despite the lower fees, "performance is the best differentiator over time," he says. "No matter what your product is, you should be able to charge a premium fee for a superior product. Like this year, active managers are putting up a solid rebound as far as performance is concerned. That's the best way for these [companies] to keep their competitive position over time."

Bogoslaw is a reporter for BusinessWeek's Investing channel.

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