Fund Trends to Watch in 2010

Bonds get some love, fees stutter, and indexing marches on.

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Investors can be a fickle lot. But for more than three decades, they've bought into one idea that has really never fallen out of favor: the mutual fund. These workhorses are in almost every investor's portfolio, and they continue to dominate the financial options available to Americans saving for college and retirement. Even as economic worries weighed on them—a recession that just wouldn't end, a drop in global markets of more than half, and a jobless rate near 10 percent, to name three—many investors focused on retirement held fast to their funds.

A March study by Vanguard Investments found that less than 1 in 7 Americans made any change to their 401(k) retirement savings plans during the crisis. At the end of last year, despite the strains of one of the worst decades in market history, Americans held more than $11.1 trillion worth of assets in funds, up from less than $900 billion in 1989. During that time, fund ownership more than doubled to 50 million households.

[See U.S. News's list of the 100 Best Mutual Funds for the Long Term, and use our Mutual Fund Score to find the best investments for you.]

Though the breadth of the market's devastation revealed that diversification is no guarantee of protection, for most individual investors "a sensible balance of mutual funds still makes a lot of sense," says Martin Gruber, the Nomura Professor of Finance at New York University. "People should be buying funds rather than trying to pick individual issues."

As they do, investors will find that they face a changing landscape. Shifting demand, new investment choices, and fallout from the downturn mean that the most common type of fund owned by average Americans—equity funds run by a stock-picking manager—will experience new competition. Demand for stock funds, which dried up during the recession, has barely reversed this year despite an ongoing market rally. "We've seen ongoing demand weakness in equity funds. It's picked up [recently], but overall demand for equities has been pretty weak throughout this recovery," says Brian Reid, chief economist at the Investment Company Institute. Here's a look at a few of the most significant trends people shopping for mutual funds now will want to consider:

[See what investors can expect from large-growth funds.]

Another Year of the Bond? Stock funds remain by far the favorite of most investors; equity funds still held nearly $5 trillion in net assets at the end of 2009, far outpacing bond and money-market funds. But after the financial crisis, something changed. Despite a stock market that came surging back in 2009, bond funds have seen record capital flows recently thanks to opportunistic buying in the wake of the crisis, a fear-induced flight to safer assets, and, above all, interest rates that are expected to hover near zero for some time to come. Bond fund sales jumped 50 percent in 2009 to roughly $800 billion. A further 17 percent increase is forecast this year. "Bonds will probably be the story throughout 2010. We won't see a big obstacle for bonds until interest rates start to go up," says Loren Fox, an analyst with Strategic Insight.

Still, that doesn't mean bonds are a "buy." It's clear that 2009 will be remembered as a legendary year, when the average total returns of bond funds topped 16 percent as fund managers snapped up all sorts of bonds at bargain-basement prices during the credit crisis. That opportunity is largely over, and investing pros are growing increasingly wary of all sorts of debt as the current fixed-income rally cools and an eventual rise in interest rates, which will hurt bond prices, seems more inevitable. Some sectors, like municipal bond funds, have seen inflows slow noticeably already.

Longer term, the question remains whether more investors will stick with bonds when the economy rebounds. Some analysts, including Reid, argue that demographic shifts favor bond-fund demand as income-seeking baby boomers approach retirement. But stock funds have been resilient even after the past decade of middling returns. They've drawn the lion's share of investing dollars for years, and it's tough to predict a real break from that stock-loving tradition, analysts say.