The wealthiest Americans who, if they desired, could put their money into hedge funds, private equity, venture capital or other alternative investments are turning instead to mutual funds.

During the past two years, Americans who have a net worth of at least $5 million (U.S.) have doubled the percentage of investable assets they allocate to mutual funds, according to research by Spectrem Group, a Chicago-based strategic consulting firm specializing in the affluent and retirement markets. Those ultra-high net worth individuals increased their mutual fund holdings from 6% in 2003 to 12% in 2005.

Why is this happening, especially so soon after reports of improper trading practices and other wrongdoing roiled the mutual fund industry?

Wealthy American investors are turning to mutual funds for a number of reasons:

• They are still nervous about investing directly in the markets and see mutual funds as a way to mitigate that risk.
• Investors were never really that concerned about the mutual fund scandals being investigated by the U.S. Securities and Exchange Commission and other government authorities.
• While many Americans have been seeking alternative investments, they define alternative as being real estate.
• There is an increasing tendency for American investors to be self-directed in their investment choices. This interest in investing on their own also increases their propensity to invest in mutual funds.
• Cash-based investments continue to be very popular, and mutual funds are considered a safe alternative to cash.

While 18% of the average portfolio is invested in individual stocks, this is down from 20% in 2003. Combine that with the fact that the average allocation to managed accounts has decreased from 26% to 23%, and clearly the overall market risk has decreased. (Managed accounts are assets invested by a professional investment manager, broker or other type of professional on behalf of an individual. These accounts are most frequently invested directly in stocks and bonds but also may include mutual funds). Despite the fact that most U.S. stock market indexes are at their highest levels since the terrorist attacks in the United States on Sept. 11, 2001, these wealthy individuals are slow to commit more money to stocks.

As you can see from the accompanying chart, wealthy individuals allocated 6% of their overall portfolio to mutual funds in 2003. They were slow to move out of the markets because they were waiting for a rebound to occur. At the same time, reports of scandals in the mutual fund industry dominated the news. New York Attorney General Elliot Spitzer was presenting new allegations of wrongdoing by fund companies almost daily. So, investors were not necessarily considering mutual funds as an alternative to the stock market.

In the second quarter of 2004, Spectrem conducted a survey of mutual fund investors to determine their attitudes about the mutual fund scandals and found that 27% of investors had little or no concern about the investigations. The wealthier investors were the most likely to believe the government and the fund companies would do the right thing and, thus, did not expect the scandals to affect their likelihood to invest.

Yet, American investors in 2003 claimed to be looking for alternatives to the stock market. However, they defined alternative investments as real estate. Even today, 8% of ultra-high net worth investors are considering “alternatives to the market, such as real estate.” While the bubble in real estate continues to remain strong, it is anticipated that Americans will begin to return to the markets as real estate values approach their all-time highs. In fact, Spectrem’s monthly surveys of investors showed a decline in real estate investing in July … the first decrease in several years.

Wealthy investors also are becoming increasingly self-directed in their investment decisions. Spectrem allows investors to categorize themselves based on the degree of their reliance on professional financial advisors. Advisor-Dependent individuals are those who allow an advisor to make all of their investment decisions. Some 20% of investors were Advisor-Dependent in 2003, compared with 13% in 2005. Advisor-Assisted individuals discuss their investments with one or many advisors but ultimately make their own investment decisions. In 2003, 23% of investors were Advisor-Assisted, compared with 24% in 2005. Special-Event investors are those who turn to an advisor only when divorce, retirement or some other major life event forces them to seek advice. In 2003, 30% of individuals were Special-Event investors, compared with 34% in 2005. Finally, there are Self-Directed investors. These are individuals who primarily make their own investment decisions. They are not day traders. They are merely individuals who make their own investment decisions because they don’t trust advisors, don’t want to pay fees or are very confident of their investment choices. Since 2003, the number of Self-Directed investors has risen from 27% to 29%. But even more dramatic is the rise from 2001, when only 20% of investors were Self-Directed.

Naturally, when investors are choosing their own investments, they may defer to something that is simple and relatively safe. This has led to the increased investment in mutual funds. Individuals feel mutual funds are not only safe because of the pooled investment but also easy to purchase, whether directly through a branch oron the Internet. Because of significant advertising, the brand names of many mutual funds are relatively well-known.

In addition, focus group research shows that many Americans are choosing to invest in index funds. They believe this investment gives them the same returns as the markets while somewhat mitigating the risk of losses.

Finally, wealthy Americans are investing in mutual funds because of a belief that they’re the next best thing to cash. Cash and cash equivalents represent 13% of the average portfolio, an historic high for the ultra-high net worth. Generally, cash represents 5% to 7% of a portfolio. As you can see from the accompanying chart, cash was 9% in 2003, reflecting the impact of the bear market. Because many investors are relatively well educated and understand that cash does not yield the greatest return, they are putting their assets into mutual funds with the belief that this investment product is relatively safe and may have a greater return than cash. It’s a way to tiptoe back into the markets.

Each month, Spectrem surveys more than 250 affluent households to determine their attitudes about the economy as well as their intentions regarding investments. This information is used in calculating the Spectrem Affluent Investor Index (SAII) TM and the Spectrem Millionaire Index (SMI) TM. Since the beginning of this monthly tracking in early 2004, the tendency to not invest or remain in cash has been very strong. Only in the past month has there been an increased interest in moving out of cash and possibly back into the markets. Hopefully, this growing interest will continue and, ultimately, have a positive impact on the markets.

What does this propensity to invest in cash and mutual funds mean for true alternative investments, such as hedge funds, private equity and venture capital? The propensity to choose these investments has not changed much over time. The truly wealthy see a place for these investments as part of their overall asset allocation. The percentage of assets in these investments rose from 5% in 2001 to 9% in 2003 then fell to 8% in 2005. The asset allocation to alternative investments is likely to remain at these levels. Individuals are more sophisticated about investments than they were in the past, and they are feeling a high level of frustration with their overall returns.

Research shows Americans are very frustrated by their investment returns. While they acknowledge the investment returns of the 1990s were unusual, many younger investors had never experienced a bear market, and they are ready for it to be over. At the same time, their propensity to stay in low-risk and cash-based investments is only adding to their angst. Despite a desire to return to the markets, wealthy Americans are using mutual funds as a way to feel more confident about their investments.

Catherine S. McBreen is Managing Director of Spectrem Group, a Chicago-based strategic consulting firm specializing in the affluent and retirement markets.