FAIRNESS IS THE PRINCIPLE THAT MATTERS MOST TO ALL

The Evolution of Investing in an Electronic Age
August 15, 2000

As a result of the growth of the Internet, the financial services sector has seen some extraordinary changes over the last few years. By making it easier for individuals to take control of their investments, the Internet has begun to democratize stock market investing and has already transformed the brokerage industry. Stocks can now be bought and sold at the click of a mouse, giving rise to a new generation of individual shareholders who pay lower commissions than ever before.

We believe that the dramatic changes to the brokerage industry are only the start of an Internet inspired financial revolution. At the other end of the investment spectrum, innovative new products are also beginning to shake-up the mutual fund industry. This article will examine the financial services industry in the light of these new offerings and give you meVC's view on the future of investing in the electronic age.

Stocks versus mutual funds: the old order
Before the Internet, investors had two choices when it came to investing their savings in the stock market: individual stocks or mutual funds. While investing in individual stocks meant that investors could pick and choose their stocks, retaining some control over how their portfolio was managed, because of high trading commissions this option was comparatively expensive, and so not really an option for the average investor.

Against the expense of individual stock trading, well-managed mutual funds have a number of advantages. These include the following:

• Diversification - Offer exposure to a wide variety of markets and sectors, which might be hard to replicate on an individual stock basis.
• Cost - They are a relatively cheap way to achieve a diversified stock portfolio, thus curbing an investor's risk for a higher return.
• Time efficient - They are time efficient, because they are professionally managed and remove the need for individual investors to conduct their own research.

While meeting the needs of many investors, traditional mutual funds are far from perfect, and do have a number of drawbacks. These include the following:

• Lack of control - Investors have little to no control over how these funds allocate their assets.
• Lack of transparency - Investors may only be given a full accounting of what's in their fund twice a year. Such lack of information may result in an investor being more concentrated in a particular stock than they would wish. This concentration usually arises when a number of mutual funds held by the investor own the same stock.
• High fees and expenses - Some funds charge high fees, which given the relative lack of differentiation between fund families these days, may seem unjustified. Moreover, these fees often leave shareholders feeling that they've been doubly penalized in periods of poor performance.
• Tax Inefficiencies - Because investors in mutual funds have no control over timing the of sales of the underlying holdings in their mutual funds, they can be stuck with a big capital gain which may translate into a large tax bill at the end of the year if a given portfolio manager is overzealously trimming positions in the portfolio. Conversely, an investor who has an individual stock portfolio has ultimate control over when a security is sold, thus controlling the timing of a potential tax bite.

The arrival of new-style funds
Over the past year a number of ground breaking new products have been introduced to try and compensate for some of the deficiencies of the traditional mutual fund. The ones that have received most attention to date have mainly tried to address the issues of transparency and individual participation in stock selection. For example, two of the most high profile new funds, StockJungle.com and Metamarkets.com, let investors know up to the minute what they are buying and selling. To a limited degree, both will also invest in companies suggested by investors.

Response of the mutual fund industry
To date, the response of the mutual fund industry has been mixed. Larger fund groups such as Janus and Fidelity, which manage relatively inflexible funds with billions of dollars in assets, understandably are not enthusiastic about changing their reporting practices. As they rightly point out, the size of their stakes in some companies are enough to move the market. If the market knew in real time what their portfolio managers were thinking, other market participants may speculate in their holdings affecting the price at which the fund would be able to accumulate or sell a particular a stock.

In contrast, other fund families have tentatively embraced the concept. For example, Montgomery Asset Management, a San Francisco-based fund family, has launched a series of funds called "Stock Solutions". These funds offer investors a full accounting of all investments, but with a two-week delay to prevent price manipulation while the portfolio manager is trading in a particular stock.

The development of the middle ground
There is no doubt that products such as Stock Solutions and StockJungle.com suit a certain type of investor: one who craves transparency, but prefers an investment professional to make all or most of their investment decisions. But by virtue of being mutual funds, they are still not able to offer the tax advantages of individual stock ownership. In fact until recently, there were no significant products offered in this middle ground: ones that offer the benefits of inexpensive diversification and individual stock ownership. New technology, however, is beginning to change this picture.

A number of totally new breeds of product have recently been rolled out, offering investors more choice and a higher degree of control over their investments than ever before. These include:

• Build-your-own portfolios - A number of online companies, such as buyandhold.com and sharebuilder.com, now allow investors to build their own stock portfolios. Investors can add to their positions on a regular basis at relatively low cost, with the tax advantages of actually owning the underlying stock.
• Flat-fee portfolios offering choice - FOLIOfn, a meVC Draper Fisher Jurvetson Fund I investment, is the first product available to go one step further than the build and hold model. For a relatively low flat fee, FOLIOfn gives investors the choice to invest and trade in existing portfolios - "folios" - or portfolio's tailored to suit their own investment preferences. In addition to the tax advantages that investors enjoy by owning the underlying stock in their folios, one of the big attractions of FOLIOfn's model is that the company has developed proprietary software to allow investors greater control over their tax liability. The software identifies which shares to sell, permitting the best possible tax treatment.

Conclusion: Something for everyone, with tax advantages on the side
As products such as StockJungle.com, buyandhold.com, and now FOLIOfn have found a ready market, some commentators have gone as far as predicting the death of the mutual fund industry. We do not believe this is likely to be the case, and this view is reflected by FOLIOfn's CEO, Steve Wallman, who recognizes that FOLIOfn "is not a substitute for mutual funds, but an alternative". After all, the success of mutual funds that use sophisticated "hedge-fund" style investment strategies, for example, depends on a level of financial expertise and time commitment that most individual investors would be unable to replicate. But as with the development of the brokerage industry, new products are forcing the industry to take a fresh look at their customers needs.

More importantly, what companies like FOLIOfn are doing is providing services and alternatives that have not been previously available. We believe that companies that are at the forefront of the electronic revolution, which have successfully identified a gap in the market, and are able to prove that they can execute their strategies, are likely to perform very well over the long run. But the ultimate winner is likely to be the individual investor. The continuing development of the financial services industry in the electronic age is likely to mean more choices at more reasonable prices. These choices should allow individuals to find products to fit their unique circumstances and level of desire to become involved in the stock selection process.

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Stockjungle.com., Metamarkets.com., Janus Funds, Fidelity, Stock Solutions, buyandhold.com., sharebuilder.com and FOLIOfnare registered trademarks, respectively, of Stockjungle.com.,Inc, Metamarkets.com.,Inc, Janus,Inc., Fidelity Management & Research Co., Montgomery Asset Management, buyandhold.com.,Inc, sharebuilder.com.,Inc, and FOLIOfn., Inc.. No association or endorsement is intended or implied. The companies named in this article are examples that have been mentioned for illustrative purposes only. meVC and its affiliates are not recommending these companies as investments.