Are star fund managers doomed?

Legg Mason's Bill Miller

For a top-notch stock fund manager, there’s nothing worse than poor returns. But one thing comes close: great performance that everyone ignores.  As The Wall Street Journal reported recently, many ace stock-pickers are having trouble attracting investors, even as they rack up double-digit return.

Consider Harry Lange of Fidelity Magellan (FMAGX), who has guided his fund to a 31% gain so far in 2009—some 15 percentage points ahead of the Standard & Poor’s 500. But during the first nine months of this year, shareholders have yanked $1.8 billion from the fund.

Investors are also slighting the once–revered Bill Miller of Legg Mason Value (up 32%; down nearly $1 billion in net cash flow); and Bill Nygren of Oakmark Select (up 40%; down $250 million).

It’s easy to dismiss these numbers are another example of classic investor bad timing. Shaken by the market plunge, many people are still seeking the apparent safety of bonds, even as they miss out on an historic rally. According to data through August compiled by Financial Research Corp., so far this year investors have  plowed more than $225 billion into bond funds, while pulling $5 billion out of domestic stock funds.

There's even bigger change at work, though: Investors are giving up on active fund managers. Even as many mutual funds are starved for cash, money is flooding into ETFs, which are basically index funds that trade like stocks. FRC predicts that exchange-traded funds will capture some $91 billion in net cash flows this year, which rivals the $100 billion expected to go into traditional funds. And by 2014, ETFs are expected to reach nearly $2 trillion in assets, a growth rate that far exceeds mutual funds.

In order to compete, some fund companies are launching their own ETFs. Fund giant Vanguard has offered ETFs for several years—it now ranks among the top three ETF providers, along with State Street and iShares. Now PIMCO and Charles Schwab are bringing out their own offerings, and even Legg Mason is thinking about it.

So is there still a future for active fund managers? Sure — there will always be investors who prefer to have a human being run their portfolios. But it's unlikely active managers will ever enjoy the same rock-star status that they once did. Question is, will star managers be able to transition into the burgeoning world of ETFs? The first ETF that allowed its managers to choose their own stocks, Grail American Beacon Large Cap Value (GVT), began trading in May; Grail is bringing out four more actively managed ETFs this month. Another new offering is Dent Tactical, (DENT), run by forecaster Harry Dent, which invests mainly in ETFs based on his view of economic trends.

So far, both of the new actively managed ETFs have attracted few investors — Grail, for example, has only $4 million in assets. And both carry expense ratios exceeding those of many regular  funds — 0.79% for Grail, while Dent charges 1.6%. That expense hurdle will make it tough for any ETF to beat its benchmark. Unless actively managed ETFs can reduce their costs and deliver the returns investors demand, star managers will continue to fade.