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Mutual Funds

The Future for Funds

After this bear market, we may see money flowing to a select few fund shops.

The apple cart is officially upset. With nowhere to hide, investors are pulling money out of mutual funds at an unheard-of pace. September was the worst month ever for redemptions. Then October doubled that rate. Because of redemptions and lost market value, the fund industry manages almost $2 trillion less than it did a year ago. Barring a huge market rally, here are a few things you should know.

Redemptions hurt you. Redemptions are usually just a minor nuisance. But three things have changed. First, liquidity dried up for many types of bonds. That means too many redemptions may cause a downward spiral, as happened at Schwab YieldPlus fund, which had to sell assets at fire-sale prices. That spurred more redemptions, and the cycle fed on itself.

Second, funds that investors thought were low-risk have been pounded. No one would bat an eye at a 5% or 10% loss in an emerging-markets fund, but people don't expect such losses from a bond fund. Third, in a case of appallingly bad timing, many funds have dropped their redemption fees in the face of pressure from 401(k) plans. Employers don't like it when employees get dinged for hopping in and out of funds, so employers pushed back and funds promptly caved. The added protection that redemption fees provided would be welcome today.

Over the next 12 months, redemptions could make a bad situation worse. Check to see whether your fund's assets have declined faster than its results would suggest. (We're adding flow data to Morningstar.com soon, which should make redemptions easier to spot.) If that's the case and your fund primarily owns high-yield bonds, bank loans or micro-cap stocks, you may want to get out.

Diversification may not help. The bear market of 2000-02 showed the benefits of diversification because many funds made money through most or all of that period. But the current bear market is demonstrating that diversification doesn't always work. Just about everything has suffered double-digit losses. If, over the next few years, some assets come back strongly, then asset-allocation models might still prove valid for cushioning the blows of down markets.

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Why is this bear market different? Deleveraging by investment banks and hedge funds has sucked the air out of all assets. Now, financial planners and fund companies alike are scurrying to come up with a better way to invest. I worry that some investors will think the answer is market timing -- as some investors always do following a bear market. The problem, of course, is that almost no one can do it well.

In the future, we may see greater tolerance for fund managers who hold cash. I'd be fine with that -- though I do remember the reason funds stopped doing so was that managers weren't very good at strategically moving in and out of cash.

Seasoned pros may get scarce. Funds are laying off back-office staff now, but the next wave will hit investment professionals. I'll be watching closely because fund companies that institute big layoffs have a difficult time making back investment losses. The problem is that the good people they want to keep will start heading for the exits along with the marginal ones. Fund companies with the cash and the perseverance to keep hiring will be winners over the next decade.

Choices will get narrower. After the previous bear market, money flowed to just a few fund companies that had done well by investors -- among them American, Dodge & Cox, T. Rowe Price and Vanguard. This time, we may see the same thing -- but the list will be different. The Pimco fund group has been drawing a lot of attention, as has Fairholme fund (see A Bargain Hunter Stands Tall). Most of the big stock-fund shops have at least some funds with big losses, so it isn't clear who else will be among the select few.

Columnist Russel Kinnel is director of mutual fund research for Morningstar and editor of its monthly FundInvestor newsletter.