Does the fund industry dare hope that a solid 2005-06 RRSP season means stronger growth in fund sales is on the way? The assets are certainly there for the taking, says a forecast, but winning the business may prove tougher than in the past.

After a few rough years, sales have revived. Mutual funds capped the RRSP season this year with a robust $3.6 billion in net sales for March, says the Investment Funds Institute of Canada, up a little from $3.4 billion in March 2005.

But that total is down from the $4.1 billion that fund sales have averaged each March over the previous 12 years, notes a report by UBS Securities Canada Inc. Nevertheless, total sales for the first three months of the year are up, to $10.1 billion, vs $9.4 billion in the same period last year.

And there is hope that sales could strengthen further. RBC Financial Group forecasts that fund sales will increase by a margin of several billion dollars this year over 2005. In a report published before the March sales figures were released, RBC predicts that fund sales will total $44 billion this year, vs $37.7 billion in 2005. It estimates the total is poised to rise to $50 billion in 2007, before retreating to $45 billion in each of 2008 and 2009, and sliding further to $40 billion in 2010.

“Our view is that we are in the early stages of liquidity redeployment that will benefit long-term mutual fund sales and direct purchases of bonds and equities,” says the report. Household liquidity (including bank accounts, money-market funds and currency holdings) has been accumulating since 2001, nearing 46% of personal disposable income vs 36% in 2001.

The last time household liquidity reached such heights was in the early 1990s. The fund industry’s first real sales boom in the mid- to late-1990s was partly fuelled by investors’ search for higher returns and their flight from comparatively poor fixed-income returns.

RBC notes that increased liquidity deployment would be the natural reaction to higher inflation. “Since much of [household liquidity] is held in instruments that offer poor inflation-adjusted after-tax returns, a rising inflation and interest rate environment during 2006 will increase the opportunity costs of holding excess liquidity,” it notes.

As the opportunity cost of holding excess liquidity on household balance sheets increases, investors may start to look for higher-yielding investments, although the liquidity build-up also hints at investors’ recent strong aversion to risk.

“This is unlikely to go on much further,” says Derek Holt, RBC’s assistant chief economist and co-author of the report. “The opportunity cost of this liquidity overhang would suggest a very cautious approach and foregone investment opportunities in recent years. It also suggests some work to be done by investment advisors when it comes to asset allocation choices among their clients.”

So far, there are signs that the liquidity deployment is underway, but it’s not clear that mutual funds are capturing their fair share of the business. Throughout the first quarter of 2006, more than $1.8 billion flowed out of money-market funds, taking assets in the funds down to $43.9 billion.

UBS reports that the asset total is about $19 billion below its peak in 2002, and accounts for only about 7.2% of industry assets, which finished the quarter at more than $608.6 billion. The allocation to money-market funds represents a new low, UBS says, “suggesting little cash from this source is available for new investment.”

Although there may still be plenty of cash on the sidelines in other vehicles, mutual funds have their work cut out for them if they expect to capture their fair share. The last time such an asset shift took place, mutual funds were more or less the only game in town for the average retail investor. Now, the competition is more plentiful — and aggressive. Indeed, the RBC report says, “The present move back into equity funds is taking even longer to unfold than the typical lagged response, partly due to the popularity of income trusts in recent years.”

To date this year, the fund industry has seen only a modest improvement in sales compared with the previous year. Although the increase is surely encouraging to the industry, it comes at a time when markets and trading volumes are booming. In the past, the fund industry would have expected more of a sales pickup in such a strong market environment.

@page_break@The asset-allocation decisions of fund buyers so far this year certainly don’t suggest that investors are chasing recent market performance through mutual funds. At a time when the Canadian stock market has been one of the best performers in the world, IFIC data reveals that just $263 million went into pure Canadian equity funds during the first three months of the year, the lowest among the major asset classes. By contrast, more than $4.3 billion went into balanced funds, the top-selling asset category during the quarter.

Holt says the relationship between market performance and fund sales seems to have broken down a bit in the past few years. “The recovery in the Toronto Stock Exchange since 2002 has not been met with the sort of surge in net industry-wide equity fund sales that one might have expected to be keyed off TSX performance,” he says. “Income trusts are probably a part of this, but so is extreme risk aversion.”

In the months ahead, qualitative factors, such as investor risk appetites, will join quantitative conditions, such as market performance, interest rates and inflation in determining whether mutual fund sales rise again.

RBC notes its forecast is based on its expectation of a gradual liquidity redeployment that may well occur at a faster or slower pace than predicted, depending on a number of factors. It puts a 60% probability on its base case scenario, a 25% probability on faster liquidity deployment (that is, even greater fund sales), and just a 15% probability on slower shifts.

Under the faster reallocation scenario, RBC estimates that fund sales could reach $55 billion in 2006, rising to $60 billion in 2007, $65 billion in 2008 and up to $70 billion for each of 2009 and 2010. Catalysts for such sales action, it says, would be sustained health in financial markets, a drop in risk aversion among retail investors and a weaker than expected pace of rate increases.

“If households redeployed liquidity relative to debt from today’s ratio back to the ratio at the end of 2000, that could fund up to about $70 billion in extra fund sales spread over time,” Holt notes.

Conversely, weak equity markets, a more rapid rate tightening and nervous investors would probably favour debt and deposit growth over fund sales growth. Holt estimates that such a scenario would mean less than $30 billion in fund sales, including reinvested distributions, and deposit growth in the 6% to 7% range.

“All in all, there are good reasons to be fairly bullish on fund sales, but the rise of the trust sector and ongoing risk aversion are unlikely to mean that the records of almost a decade ago are about to be broken,” says Holt.

Although RBC expects households to gravitate naturally toward more investing through the redeployment of their excess liquidity, the firm also notes that they could use a push in that direction from governments.

“Policymakers should be aware of the need to coax households in the direction of redeploying liquidity toward purposes that are not inflationary, such as higher saving and investment,” the report says.

Holt says following through on promises to lower capital-gains taxes would be one way to nudge households toward greater saving and investing. Reduced capital gains taxes would shift the investment horizon of households, and encourage investing over spending, he says.

Sales records may not be in the cards but fund firms can take comfort: the liquidity tide may be turning in their favour once again. IE