Mutuals May Tap Synthetic Securities

In the fashion world, there’s nothing quite like synthetic fibers for transforming haute couture into mass market knock-offs. In finance, there will be nothing quite like synthetic securities for spinning mutual fund knock-offs.

By the end of this decade, highly marketable off-the-rack blends of synthetic securities--options, futures and other so-called derivatives--are going to redesign the $1-trillion mutual fund industry in ways we can’t yet anticipate. As surely as mutual funds reshaped personal investment in the 1980s, these instruments--tailored for mass consumption--will help set the personal investment agenda for the 1990s. If nothing else, the rise of synthetics will redefine the mutual funds themselves.

“I think there’s every reason to believe that the mutual fund business will move in the direction of complexity and derivatives,� asserts Peter L. Bernstein, founder of the Journal of Portfolio Management and author of the forthcoming “Capital Ideas,� a history of modern finance. “It’s a competitive business, and you’ve got to keep finding niches.�

Of course, Wall Street and Chicago have been engineering and selling synthetics for institutional clients for years. Even as the 1980s witnessed a 700% rise in mutual fund assets, the decade saw a comparable explosion of institutional investment in synthetics--with decidedly mixed results. Remember portfolio insurance?

Nevertheless, increased knowledge, competition and creativity should combine to create an array of compelling “options� for individual investors. Like biotechnology and computer technology, financial technology will gradually accelerate into the consumer market.

For example, financial engineers assert that it is both theoretically and technically possible to use synthetics to cheaply replicate the performance of existing mutual funds. That is, you could create a blend of options and futures to mimic the equity holdings of, say, Fidelity’s Magellan Fund. Because the cost of managing such a synthetic mutual fund should be less than the cost of managing the real thing, an investor could essentially buy into the fund at a permanent discount--maybe yielding an extra 1 or 2 percentage points of return.

“There might be special opportunities in global markets that you could take advantage of,� says Goldman Sachs’ Fischer Black, co-creator of the Black-Scholes Option Pricing equation that transformed modern finance. “You could create, for example, a fund that might want to invest in German equities. Instead of buying the stocks directly, you might want to invest in the (German options market) . . . the savings for doing that are more in foreign markets.�

Most equity investment funds are simply “much more inefficient than they need to be,� asserts Susan Webber, a New York-based consultant to financial institutions, “and that exploits the customer’s lack of alternatives. Synthetic mutual funds offer a way to provide a better mousetrap.�

“I think people are dreaming if they think they can create a synthetic Magellan Fund,� says John C. Bogle, chairman of Vanguard Group, a family of funds that manages over $72 billion in assets. “I think it would be a remarkably difficult thing to accomplish.�

While Vanguard is keeping its eye on synthetics opportunities, and the regulations that govern them, Bogle says, “I would be flabbergasted if there were ever 25% of funds invested in synthetic funds.�

Then again, even 10% of $1 trillion is $100 billion. As institutional investors well know, often to their horror, what happens in the derivative markets can have an enormous impact on the equity markets.

The marketing challenge will be to create synthetic mutual funds that people believe are as safe and well-managed as traditional mutual funds. Only 20 years ago, Webber notes, mutual funds themselves were held in low regard. Now they are regarded as the most stable equity investments around. As these faux funds take off, investors could get something they want from every market: more choice at lower cost.