Fund flows show a smart move by 'dumb money'

David Peartree, The Daily Record Newswire

Individual investors collectively are viewed as “dumb money” by much of the investment community. The polite way of expressing that harsh assessment is to say that individual investors are viewed as a contrarian indicator.

A contrarian indicator is one which tells you to do the opposite of what the indicators say is occurring. When investment professionals cite the investing patterns of individual investors as a favorite contrarian indicator, the idea is to find out what these investors are doing with their money and then do the opposite.

If individual investors are pulling money out of stocks, that is a signal to buy stocks. If they are piling into bonds, that bodes ill for bonds. The assumption is that individual investors typically invest in the wrong asset at the wrong time, that they let their emotions get the better of them causing them to miss opportunities or take on unsuspected risks.

Over the past several years the financial press has repeatedly pointed out that, starting late in 2007, individual investors have been pulling money out of stocks and piling into bonds. The suggestion is that these investors are missing out on the recovery in stocks and setting themselves up to have their bond portfolios burst when interest rates rise and bond prices fall.

The facts are actually more nuanced and paint a much more favorable picture of the performance of the typical individual investor.

It is true that US stock funds saw heavy outflows last year, in excess of $119 billion. Morningstar reported that outflows from actively managed US stock funds last year were comparable to the record outflows in 2008. Bond funds, on the other hand, saw heavy inflows, approximately $300 billion. Moreover, over the five-year period from the third quarter 2007 through the third quarter 2012, investors have pulled approximately $400 billion from U.S. stock funds.

All this is true, but not the complete truth. “The rest of the story,” as Paul Harvey would have said, shows a more thoughtful pattern by investors.

First, while the outflows are big numbers, they are not indicative of a panic or mass exodus when measured against a multi-trillion dollar market. At the start of 2012 the US mutual fund market held $11.6 trillion, about 50 percent of which was in stocks. Roughly 35 percent was in US stocks and 15 percent in international stocks. An outflow of $119 billion from U.S. stock funds in 2012 represents about a 2 to 3 percent downshift in U.S. stock ownership in mutual funds.

Second, many of the dollars that left U.S. stock mutual funds merely shifted to other stock investments. The large outflow of dollars from actively managed U.S. stock funds coincided with large inflows into passively managed index tracking funds, especially exchange-traded funds. U.S. stock ETFs have seen net inflows every year from 2007 through 2012, except during 2009.

Balance the net outflows from U.S. stock mutual funds with the net inflows into ETF stock funds and the net outflow from all U.S. stock funds over that five-year period is only about $230 billion. It indicates a modest decrease in collective stock ownership by individual investors, but it’s not evidence that individual investors have given up on stocks.

Third, consider who owns stock mutual funds. Mutual funds are owned predominately by older investors. Nearly 40 percent of mutual fund owners are age 55 and older, and 70 percent of the dollars in U.S. mutual funds are owned by Baby Boomer and older generations. These investors are either already retired or are heading there in the not too distant future.

The real story may be that more investors are giving up on actively managed stock mutual funds or at least have decided to shift more of their investments to less expensive, passively managed index tracking funds. The fact that the heaviest outflows have been from the most expensive mutual funds confirms that investors are acting thoughtfully and not simply pulling the plug on stocks.

An increasing number of investors are no longer willing to overpay for underperformance. A recent news release by Reuters cites an analysis by Goldman Sachs showing that only 36 percent of actively managed funds beat their benchmark in 2012. Only 12 percent of hedge funds — supposedly, the sophisticated, smart money — beat the S&P 500 last year.

The typical investor actually appears to be acting quite sensibly. There is no denying that investors are wary and that some dollars have shifted over the past several years from stocks to bonds, but overall stock ownership by individual investors is still close to 50 percent. Having suffered through two severe bear markets since 2000, investors are now a decade older and perhaps wiser.

Increasingly, these investors are looking to efficiently capture market returns at the lowest possible cost. The flow of their dollars from high expense, underperforming funds into low expense market capturing index funds is an unmistakable trend.

That’s a smart move by “dumb money.”

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David Peartree, JD, CFP is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. He can be reached at david@worthconsidering.com.

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