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Originally published January 6, 2013 at 9:50 AM | Page modified January 6, 2013 at 9:49 AM

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Chuck Jaffe: Fearless fund forecasts for 2013

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Legendary economist John Kenneth Galbraith once said that the only function of economic forecasting “is to make astrology look respectable.”

Thankfully, I don’t forecast the economy, only the mutual-fund business for the year ahead.

In more than 15 years of doing this at the start of each year, I typically have gotten about three-fourths of my forecasts right, and been early on one other, which I would like to think is at least a bit more reliable than stargazing.

In rooting around the fund industry doing my job, I have come up with eight big stories that I think will dominate the fund world in 2013.

They won’t dominate the news or the economy the way the “fiscal cliff” has in recent weeks.

But they will set the tone for how investors are feeling about mutual funds 12 months from now,

Fund-industry headlines in 2013 will include:

A massive move by some big names into ETFs.

One oddity in the evolution of exchange-traded funds is that Vanguard effectively has been the only fund firm allowed to create an ETF share class for its traditional funds (Vanguard actually has a patent on the process, which expires in 2019).

Other big players, however, have approached the U.S. Securities & Exchange Commission about allowing for a “hub-and-spoke system,” where ETF versions of traditional mutual funds could be created as an extension of the existing issue.

In short, it’s different from what Vanguard does mostly in semantics, but that should be enough.

Assuming the SEC approves the plan, expect Fidelity and State Street to jump in hard, and for firms like T. Rowe Price and others to follow suit.

In short, the ETF landscape will look a lot more like the traditional fund world in terms of who the big players are.

Active mutual funds being converted into ETFs.

A continuation of ETF expansion, this time with companies overcoming hurdles that the SEC has put in front of actively managed funds that wanted to change structures to become ETFs.

There already are active ETFs, but the expected boom in this segment of the business has not occurred, in part because regulators have not approved these conversions.

That said, it looks like a few fund sponsors may be able to jump the hurdles and get conversions done this year.

Once that happens, it will be a race between the conversions and the hub-and-spoke expanders to get their issues to market.

New ETFs igniting a price war.

When the first two items occur, there will be a fun, good-for-investors follow-up.

Consider the pricing structure on Bill Gross’s ETF version of Pimco Total Return (BOND).

It’s cheaper than his retail fund, not quite as inexpensive as institutional-share classes, due to underlying expenses inherent in traditional funds.

While fund firms could make conversions to ETFs and hold pricing steady — or make it slightly better akin to Gross’s fund — the more likely way for some of the new funds to stand out is to slash costs as much as possible.

So the story won’t just be about investors getting a raft of new ETF choices, but getting them more cheaply, further hastening the industry shift to ETF dominance.

Renewed talk about 10-year returns.

Now that the bear market of 2000-2002 is completely out of 10-year track records, the last decade only has one bear market — spurred by the financial crisis of 2008 — and the last decade shows a 7 percent annualized average gain on the Standard & Poor’s 500.

That’s not bad at a time when most investors are shunning stocks for the safety — and ultralow returns — of bonds.

So funds with records equal to or better than the market can now show solid three-year records (the S&P is up more than 10 percent per year over the last three years) and long-term records; that is where the advertising will focus.

By the end of the year — when the worst of 2008 falls off the five-year record — funds will be thumping their record over the last half-decade, too.

Approval for the next-generation money fund.

Since the financial crisis, there has been talk of reforming money funds, either by allowing for variable share prices or taking other steps that help ensure that shares accurately reflect the value of underlying assets.

With yields being so low, regulators can move on this in 2013 without consumers much caring.

So they will push something through that most likely won’t be discovered as truly ineffective until the market stress-tests it at some future point of crisis.

Whatever the outcome, expect it to make short-term bond ETFs an increasingly popular alternative, furthering the industry shift toward ETFs.

A complete shrug over changes in tax rates.

Despite the “fiscal cliff” focus, the talk and hype about how tax changes affect fund investors will be much bigger than the reality.

With nearly two-thirds of fund assets in retirement plans, shielded from taxes, fund investors will be among the least-concerned members of the investing community when it comes to tax changes.

A derivative blowup.

A big trend in fund investing since 2008 has been funds that hedge away risk.

From absolute-return funds to balanced-risk issues, these funds combine market exposure with some form of insurance that makes it appear like they won’t lose money.

The problem with these downside-protection funds is that they use derivatives and other complex financial instruments to protect shareholders.

If there is any sort of economic shock in 2013, people who rushed into these funds will be sorely surprised as to how badly they get hurt, because some of these small funds are running issues that their managers barely understand and the market routinely punishes that kind of hubris.

Investors in long-term bond funds discovering their safe haven provides neither security nor sanctuary.

Investors have been flooding into bond funds despite the low returns.

They have been emboldened by statements from the Federal Reserve that rates will stay put until 2014 or beyond.

While the Fed can hold short-term interest rates steady, expect 30-year Treasurys to tick up before 2013 ends.

When it happens, long-term bond funds will get hammered, and you will hear a lot of talk about the first signs of a bond bubble ready to burst.

And if the economy goes into a recession — which I think it can avoid — the picture in junk bonds could get ugly, too.

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com or at P.O. Box 70, Cohasset, MA 02025-0070.

Copyright, 2013, MarketWatch

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