Mutual funds expose investors

US INVESTORS continued to pour a record amount of money into mutual funds last week, underscoring a systemic financial trend that policymakers have only recently begun to address.

Over the past decade, with interest rates dropping to historic lows, Americans have developed a love affair with equity funds, money market funds and other forms of non- traditional finance that in effect have created a parallel banking system. Today, mutual funds are overtaking banks as major repositories of US household wealth as well as suppliers of capital to small and medium-size companies. Yet the US financial system still operates around a universal banking model that no longer exists.

This could have profound political and economic consequences over the next two years in the event of a major bear market, which many on Wall Street now predict.

Only slowly over the past two years has it dawned on Washington that the US mutual fund industry has grown into a dollars 2,000bn ( pounds 1.340bn) Goliath in response to the Federal Reserve's low interest rate policies. So strong is the industry's hold on US investors that despite the 4 per cent drop in the Dow Jones Industrial Average last month, they continued to pour a record dollars 18.3bn into equity funds. The most recent industry survey indicates that 28 per cent of US households now own a mutual fund, against only 6 per cent in 1980.

Since these data do not reflect company plans, total ownership of funds is estimated to cover more than 35 per cent of Americans, who have watched their assets grow dramatically during the prolonged bull market in the US.

But there are also some potentially dangerous side- effects that are only now being discussed. To begin with, surveys indicate that many buyers of mutual funds - notably shareholders of bank mutual funds that have assets of nearly dollars 180bn - are unaware these assets are uninsured.

Many consumers are unable to make the mental leap from traditional bank deposits, backed by government cover, to the uninsured assets of funds in the parallel banking system. Raising the level of consumer awareness is one of the new targets of the US Securities and Exchange Commission.

Additionally, the SEC is deeply concerned that bank regulators are poorly equipped to handle what it foresees as a tidal wave of bank acquisitions of mutual funds over the next few years. Last week Arthur Levitt, the SEC chairman, warned that Mellon Bankcorp's pending acquisition of the mutual fund business of Dreyfus Corporation raised serious supervisory problems. He claimed that bank regulators lack the experience to deal with the securities industry and have different goals to protecting investors.

'This is not something you come by in a manual,' Mr Levitt said, adding that the SEC fears banking authorities will not be able to spot fraud and punish it. Currently, banks are exempt from SEC supervision.

The pending merger has created a regulatory war in Washington. Eugene Ludwig, the top US banking authority as Comptroller of the Currency, responded last week that his officers had the required expertise. He also stated his belief that mutual fund acquisitions would contribute to the stability of US banks.

The dramatic growth of mutual funds could also spell big political trouble in the event of what the New York Times describes as the new investment nightmare - 'a creeping crash'. Instead of the market 'meltdowns' experienced in recent years, Wall Street investors now fear the 1990s version of the epic bear market of 1973/4, which lasted for 21 months, eroded share prices by 50 per cent and caused widespread panic and pain. Such a market is not known to the new generation of US investors.

Given such an investment climate - in which not just a few million people but more than 20 million US households would be affected - there are bound to be severe psychological and economic reactions. Those who have found a comfortable home in markets may have to sell shares at a considerable loss to finance house purchases, university educations or retirements. Even if there are only paper losses, people who have never been through a bear market before will feel much poorer and the economy as a whole could suffer. And the prospect of such a development seems very strong given the recent rise in US interest rates and the indications from the Fed that it will do more of the same in response to robust economic growth.

There are other macroeconomic and global considerations. Record numbers of Americans have been investing in funds specialising in emerging markets or foreign equities. This outflow of capital has resulted in a boom on Asian and Latin American markets that could turn to bust if these investors retreat.

Finally, the growth not just of mutual funds but the entire range of investments in the parallel banking system may severely restrict the Fed's ability both to feel the pulse of the US economy and then to influence it.

The parallel system greatly reduces the primary role of banks in transmitting monetary policy and deploying central bank liquidity to prevent disruptions and manage crises. Even the Fed acknowledges that its traditional leverage in the markets is falling away.

So for better or worse, there is bound to be more government intervention in the parallel banking system, with the main focus on mutual funds.