Who Will Survive the Mutual-Fund Shakeout?

In a struggle that will almost certainly result in fewer and larger players, fund management companies are using diverse tactics to compete for a shrinking asset pool. After spectacular stock market losses and client withdrawals, firms seek a competitive edge in various ways as the industry consolidates.

Industry insiders expect radical change. Mohammed El-Erian, chief executive of bond giant PIMCO, recently wrote about the coming shrinkage and consolidation of the asset management industry. His prediction: the winners will be managers that use defensive strategies to avoid losses and take advantage of others’ mistakes.

Easier said than done, but El-Erian has earned his bragging rights. PIMCO and index pioneer Vanguard led mutual fund companies in sales last year, with the PIMCO Total Return Fund attracting the most money — $17.9 billion net of withdrawals. Overall, bond and index funds performed better in the crisis than actively managed stock funds.

Most likely the bigger fund companies will get even bigger, but in the process are likely to focus less on individual account holders, says Eric Lansky, president of USA Mutuals. Small firms like his have a much harder time making their way into the fund rosters employers offer as options in 401(k) plans, which account for much of the money invested in mutual funds.

Big players have the advantage of long-established relationships with consultants and financial advisors. Fidelity, long the fund-industry leader, found focusing on those relationships a bright spot in what was otherwise a very bad year. The company says it expanded services to intermediaries like registered investment advisors and sold a record number of 401(k) plans through advisors in 2008.

Smaller fund companies, though, hope to benefit from some opening trends in the retirement market. A growing number of 401(k) plans now provide open platforms, meaning that employees have the option of investing outside an established menu of funds using accounts set up at brokerages such as Ameritrade or Charles Schwab.

Does a little-known fund manager have a chance against, say, Fidelity, in getting a piece of someone’s retirement savings? USA Mutuals’ Lansky certainly has a battle plan. “Our strategy is to engage the individual,” he told me. “The big boys go after the big advisors, big 401(k) plans. But at the end of day, it’s an individual who is investing. That’s who we’re speaking to.”

In particular, he’s pitching to individuals who have first-hand experience with certain industries. USA Mutuals’ Vice Fund specializes in “sin” industries like alcohol and tobacco. Who knows about liqueur sales and which brands of liqueur are selling? Bartenders, of course. So Lansky is reaching out to bartenders via online marketing, arguing that it is best to invest in what you know and understand. It’s a far cry from the mainstream industry, but he’s aiming to get a small slice of the pie.

Meanwhile, the pie keeps shrinking. The combined assets of American mutual funds continued to fall in February, from $9.6 trillion in December to a little over $9 trillion. Fidelity still accounts for a sizable chunk of the total, even though its assets declined from $1.4 trillion to $1.2 trillion just in the three months ended December 2008.

For Fidelity, the pivotal question is how much money can be gathered via its network of advisors and broker-dealers. Well-known Fidelity funds lost heavily in the stock market turmoil. Fidelity Magellan, once the largest mutual fund in the world with more than $100 billion in assets, dwindled to $16.7 billion after losses and withdrawals.

With equity market pain fresh in investors’ memory, stock-oriented Fidelity has been at a disadvantage competing with PIMCO the bond expert or Vanguard the index specialist. And then there are hundreds of contenders hoping to expand in little niches.

It’s a time of unprecedented change, says PIMCO’s El-Erian. So far, the change has brought pain rather than gain. Fewer assets meant less revenue and smaller staff not only at Fidelity but other major money managers. Over the past several months, American Funds, BlackRock, Putnam and Fidelity have all announced layoffs.