Crystal Ball

Flood of new fund product on horizon

Barry Fennell, Senior Research Analyst at Lipper

With more than 12,000 different share classes of equity mutual funds and over 6,000 share classes of taxable bond funds, one might assume the fund industry has launched a sufficient number of products to adequately cover every conceivable asset class, sector or investment strategy.

Additionally, there are more than 1,000 equity and almost 400 taxable bond exchange-traded funds available that track everything from short-term natural gas futures to the Russian equity markets and semiconductor stocks.

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The fund industry, however, historically has liked to create products to diversify its asset base in the hope of generating additional revenue. In the future, look for new mutual funds and ETFs that focus on income solutions—to meet the thirst for income demonstrated by growing numbers of retirees—and those that address retirees' risk-aversion in the wake of equity-markets gyrations over the past 15 years.

Building on the risk-aversion and capital-preservation themes, also look for new funds that come with a stated goal of delivering consistent returns. Those will come in the alternative-investment space: absolute return and market-neutral products or some variation that emphasizes event-driven outcomes.

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Additionally, indexing with a "twist"—so-called smart-beta strategies—will be promoted by fund companies as an alternative or middle ground to traditional indexing and active management.

New funds focused on income solutions will be in demand, largely as a result of the macro investing environment. Following a three-decades-long bull market in bonds, the search for yield remains in full force. Yield compression and the resulting bond price appreciation have also added to the income-solution challenge by reducing the number of attractive capital appreciation opportunities available in fixed income.

Products that have a tactical component—which can be utilized effectively to allocate across the different segments of the fixed-income universe to those the fund manager perceives as having the most attractive relative valuations—have strong appeal, particularly for investors seeking both greater yield and total return.

Unconstrained and alternative-income funds have been launched to help meet this demand, and their number should continue to grow.

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For example, a recently launched unconstrained bond fund with this "go anywhere" philosophy is the Neuberger Berman Unconstrained Bond Fund. The driving rationale behind these alternative credit products is that in order to achieve an attractive total return in a low-yield/limited-capital-appreciation environment, a fixed income–oriented investor needs a fund manager who can rapidly take advantage of new opportunities without the constraints typically imposed on a "traditional" bond fund.

This unconstrained strategy has proved popular recently. Since Lipper began tracking the net flows of the alternative-credit-focused peer group in September 2013, $19.4 billion net has flowed into mutual funds and $19.3 billion into ETFs in the classification through February 2014.

Liquid alternative-investment funds and absolute-return funds are other strong growth segments, most of which were unavailable to fund investors until recently. Investors find these products particularly appealing for their portfolio-diversification benefits and their perceived ability to provide positive absolute returns in different market environments.

The number of these products will continue to increase as financial advisors find they have broad appeal in periods of heightened volatility.

Some investors are also concerned about the future direction of equities and the prospects for fixed income after the bond market disappointed in 2013. These uncertainties have left many investors concerned about preserving capital and prioritizing diversification.

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Making money in fixed income
Making money in fixed income

Absolute-return funds strive to achieve these goals and should remain popular as a result. Absolute-return funds aim to produce positive returns in all market conditions and are not benchmarked against a traditional index; rather, they aim to outperform a cash or risk-free benchmark.

Putnam Absolute Return 300 Fund falls into this category. It attempts to provide a 3 percent return over inflation by typically using an allocation of relatively conservative investments, such as investment-grade corporate bonds or Treasurys.

The fund, while significantly lagging the S&P 500's total return for 2013, largely accomplished this objective by returning 4.35 percent. Results such as these will continue to attract assets from those investors who are unsatisfied with fixed-income yields but who also are not comfortable with the risk associated with even conservatively positioned equity income–oriented funds.

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Other similar approaches that should continue to see new funds added include hedge fundlike strategies such as market-neutral. Market-neutral funds often attempt to limit or "neutralize" the impact that market return has on the portfolio by being both long and short. This has appeal for investors who are looking for both diversification and reduced volatility.

Two funds following this approach are PIMCO Worldwide Fundamental Advantage Strategy Fund, which has gathered significant assets over the past two years, and Vanguard Market Neutral Fund.

Smart-beta approaches should also see new fund launches as this approach gains greater traction, particularly among those who favor index investing. Smart-beta approaches are designed as alternatives to traditional market capitalization-weighted index investing, which can often have significant weightings in larger names.

Enhanced indexing is a popular smart-beta strategy that continues to attract a lot of net inflows. Enhanced indexing strategies typically attempt to reduce overall volatility by de-emphasizing larger-capitalization names. The strategy is attractive because of its low expenses relative to those of traditional active managers and its overall simplicity.

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Fidelity Large Cap Core Enhanced Index Fund is an example of a fund that tries to generate excess return compared to the S&P 500 by using quantitative screens. The expense ratios of these types of products are generally higher than those of traditional index funds. For example, the annual total expense ratio for FLCEX is 0.45 percent, while that for Vanguard 500 Index Admiral Shares is 0.05 percent.

Some examples of smart-beta products include:
Equally weighted: Perhaps the simplest form of smart beta; each security's weight in the index mirrors the other constituents'.
Fundamentally weighted: Index constituents are ranked by metrics such as dividends, cash flow, book value or sales.
Low volatility: Constituents are ranked with an emphasis on lowest beta.
High-beta: These products place an emphasis on constructing indices with higher-beta constituents.
Enhanced indexing: These products seek to bolster passive-strategy returns with reduced volatility by typically de-emphasizing larger market-cap constituents.

There are other variations of smart-beta strategies that attempt to emphasize a particular characteristic of an index. One straightforward smart-beta approach is to equally weight every stock in a particular index, while another is to use stock fundamentals to emphasize stocks with a "value"-oriented bias; stocks that have higher-than-average dividend yields are favored. Look for the number of fundamentally oriented smart-beta funds to also increase.

Barry Fennell is a senior research analyst at Lipper, specializing in mutual fund research and performance analysis.