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Personal portfolios surge

Karen Krebsbach (Thomson Financial Media) -- The growing popularity of a new kind of alternative investment vehicle promises to revolutionize the industry like no other product in recent memory but also threatens to become a regulation headache for the Securities Exchange Commission.

"Personal portfolios," which combine model portfolios with advice, trade execution and favorable brokerage fees, are becoming increasingly popular for investors seeking "a middle ground" between mutual funds and simple brokerage accounts, according to a new report by TowerGroup's Robert M. Hegarty, director of investment management technology research.

By 2003, he predicts the U.S. market in personal portfolios will be worth nearly $25 billion, up from just under $1 billion today. Still, that's just a tip of the $7.3 trillion mutual fund iceberg. "Because the investing public is so large and getting larger, there will soon be room for all of the players, traditional and disruptive," he says. "With so much money flowing into these investment vehicles, and so many retirement investors employing the buy-and-hold approach to investing through mutual funds, it is unlikely personal portfolios will steal a significant amount of assets from the mutual fund industry."

Indeed, client demand is expected to prompt a handful of mutual fund giants-such as Fidelity and Schwab-to roll out their own versions of the personal portfolio within the next few weeks, which will probably force the SEC to rule on whether these vehicles be regulated as mutual funds or as securities, predicts Hegarty.

SEC officials, who declined comment on the issue, did say they expect to tackle the issue in the first quarter of 2001, thanks to a July 12 letter of complaint from mutual fund trade group Invest-ment Company Institute (ICI) about Vienna, VA-based Foliofn, the first broker-dealer to market the vehicle. Hot on Foliofn's heels are Netfolio, MyMoneyPro, Maxfund and eInvesting, which as of press time, had not begun operations. "Programs like these replace the investment company shareholders' undivided interest in a securities portfolio with book-entry ownership of the portfolio securities by individual investors," the ICI says in its letter, noting that Foliofn hasn't registered its products under the 1933 Securities Act or the 1930 Investment Company Act. "Because of book-entry ownership, and because investors can elect to customize their portfolios, (companies believe they) can avoid advertising restrictions, disclosure requirements, self-dealing prohibitions, fee and sales charge limits and other basic characteristics of the regulatory pattern framed by the 1933 and 1940 acts."

Absent regulation, the ICI argues firms could use such vehicles as "dumping grounds" for securities inventory, including from unsuccessful underwritings or proprietary trading programs.

But Hegarty isn't so sure, and predicts the ICI's efforts will ultimately fail. "The concept has already been vetted through regulatory authorities," he notes. "And similar products to thwart product innovations-money market funds, sector funds-have failed to be adopted. Eventually, mutual fund firms will embrace the personal portfolios as an alternative investment vehicle for their customers." In cases where no additional regulation is recommended, the SEC often issues "no action" letters, which Hegarty expects in this case.

Nancy M. Smith, vp for Web content and investment education at Foliofn, pooh-poohs the ICI's complaints, saying, "It's not an issue. Most securities' lawyers believe that its arguments are far-fetched. With folios, there's no pooling of monies with other investors. They aren't mutual funds. You can trade those stocks whenever you want. There's no parallel in terms of mutual funds."

Eventually, Hegarty believes personal portfolios will "revolutionize the individual investing market," though not at the expense of mutual funds or brokers. "Personal portfolios will not decimate the mutual fund industry, as some have forewarned," he says. "Rather, they will become a preferred alternative investment vehicle. Mutual fund firms and other investment management firms now can anticipate customers' demands by developing customizable portfolio products."

Personal portfolios appeal to several market segments, including disenchanted mutual-fund investors, frustrated stock pickers and capital-gains taxpayers, cost-conscious index-fund investors and technology-savvy Internet investors. "As with any disruptive technology, personal portfolios are a product of an entrepreneurial goal to fill a perceived need in the marketplace," says Hegarty, pointing out that mutual-fund investors have been dissatisfied with their funds' underperformance, compared to stocks, in the bull market.

"Personal portfolio firms are wedging their products between the two major classes of individual investors: stock pickers and mutual fund investors," he adds. "They appeal to mutual fund investors, due to their increased tax efficiency and greater control over holdings. They appeal to stock pickers because they provide professional guidance and lower transaction fees." Unlike mutual funds, personal portfolios allow the client to select his own stocks and manage the tax consequences himself.

A key driver of the emergence of personal portfolios has been the Internet, which has provided greater availability of stock research, leading to more active investors. The Internet also brings together previously disparate parties, allowing buyers and sellers of stocks to trade with each other more readily.

But perhaps the most important driver has been reduced fees and trading commissions. "Although a personal portfolio's expense ratio is not the lowest available, it is lower than a traditional mutual fund when its assets get above the $14,000 threshold," says Hegarty, who points out that a personal portfolio's assets must be above $13,900 to offset the lowest annual fees for such vehicle, which average 1.44%. "These firms have taken advantage of these reduced commissions to permit clients to trade more frequently and with fewer restrictions," he adds. However, Hegarty admits this vehicle is not without problems. "Perhaps the greatest challenge is demonstrating that portfolio investing will achieve better results than index fund investing, and will be worth the extra work required of the individual investor," he says. But do-it-yourself investors will flock to this vehicle.

(c) 2001 Thomson Financial

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