Redemption Song

Will mutual funds drag down the market?

The latest numbers on money flows—the monthly indicators of whether investors are buying or selling mutual funds—are in, and they’re not pretty. This summer, according to the Investment Company Institute, investors essentially pulled out more than $73 billion from U.S. funds that invest in stocks. If things don’t perk up in the fall, 2002could wind up being the first year since 1988 in which more money goes out of stock mutual funds than goes in.

The fact that mutual-fund investors are throwing in the towel may seem like a fresh cause for concern. After all, these credulous long-term investors continued to plow record sums of cash into stock mutual funds even as the market plummeted in 2000 and 2001—so if they’re pulling out now, things must really be bad. And at first blush, it might seem impossible for the market to rise while one of the most stalwart cohorts of the investor population sings the redemption song. But individual investors—whether they’re buying stocks on their own or through mutual funds—have always been poor market timers. And the relationship between money flows and stock performance is like the marriage of Bill and Hillary Clinton: It’s complicated.

For much of the 1990s, if you watched CNBC attentively—try to think back to the time when people actually watched CNBC attentively—a certain species of analyst would brush off the high price-to-earnings ratios with the reassuring nostrum that “we’re in a liquidity-driven” market. Translation: The continual flow of cash into the bourses, much of it coming through mutual funds, was a crucial source of support for the sky-high prices. As the decade and the bull market wore on, an increasing number of investors essentially placed their investment decisions on autopilot, channeling a fixed sum of money from their bank accounts or payrolls into stock mutual funds via brokerage accounts, IRAs, or 401(k)s.

As the bull market broke down and individuals suddenly began to realize the risk of holding volatile individual stocks, they drove even more money into more stable mutual funds. In 2000 and 2001, net inflows of U.S. stock funds were $260 billion and $54 billion, respectively.

Mutual funds were buying while corporate insiders, companies themselves—in the form of IPOs and secondary offerings—and other individual investors were selling. In 2001, mutual funds bought an estimated $120 billion of stocks on behalf of U.S. households, while households sold an estimated $295 billion of stocks held outside mutual funds. As the American love affair with equities waned, according to new data from the ICI, the number of households owning individual stocks fell 4.9 percent between January 1999 and January 2002, from 26.7 million to 25.4 million. The number of households with mutual funds, on the other hand, rose—from 51.7 million in May 2000 to 54.8 million in May 2001.

So any signs that mutual-fund buyers are getting cold feet should spell trouble, no? Not necessarily. First of all, despite their rampant growth, mutual funds today own only about 21 percent of the overall market. The rest is held by insurance companies, pension plans, banks, and individuals.

Besides, the theory goes, individual investors—whether they’re buying stocks or mutual funds—chase returns, they don’t create them. Fund flows are a “lagging indicator,” says Brian Portnoy, a fund analyst at Morningstar. “They have almost no predictive quality.” How else to explain the action in 2000, when a record amount of inflows coincided with dismal returns? And, he notes, the amount of cash chasing stocks, or running from them, is just one of many complex factors—such as corporate profits, interest rates, war fears, scandals, inter alia—that can influence stock prices.

A study by the Federal Reserve—admittedly a bit dated, since it examined data from 1984 through 2000—mildly disagrees. It found that money flows and stock prices seem to move in the same direction in any given month. But the researchers, Eric M. Engen and Andreas Lehnert of the Federal Reserve’s division of research and statistics, couldn’t find a causal relationship. A rise in the market in one month doesn’t cause greater inflows the next month, and positive flows, in and of themselves, don’t cause prices to go up. “There is little evidence that over the past decade or so mutual-fund investors have traded in a manner that has significantly influenced stock prices independently of the rest of the market,” they conclude.

Of course, if investors throng to the exits en masse,like Knicks fans clogging the aisles at Madison Square Garden in the fourth quarter, they could prove disruptive.When individuals redeem their shares, mutual-fund managers without a sufficient cash position may be forced to sell stock—which could exert what pros like to call downward pressure on the market. In recent months, these redemptions may have helped drive down the prices of some individual stocks owned by out-of-favor fund complexes like Janus.

Nonetheless, the data from the past three months may prove troubling if it signals the beginning of a larger trend. Historically, stock mutual-fund investors have not been easily spooked. The vast majority seem to have internalized the mantra of holding on for the long term. Indeed, the Fed study found that mutual-fund investors—many of whom use the funds to save for retirement—have such long time horizons that they have become inured to the slings and arrows of the market. In the wake of the October 1987 market crash, only 3 percent of assets were withdrawn from stock mutual funds. In August 1990, when Iraq invaded Kuwait, the monthly outflow was just 1 percent. And in August 1998, when the Russian and Asian crises came to a head, 0.3 percent of assets left the market.

But the recent market turmoil seems finally to have jolted mutual-fund investors from their collective complacency. The recent withdrawals total about 2.1 percent of the total assets that were in stock funds as of last May.One potential danger is that investors increasingly will channel their mutual-fund investments into money market funds or into bond funds. Bond funds, for example, have experienced a net inflow of $86.5 billion through July and are on their way to racking up a record year.

Mutual-fund investors are but one demographic in the investor population. Aside from institutions like pensions and insurance companies, other purchasers of stock include: individuals; companies who buy back their own shares or those of other companies through acquisitions; leveraged buy-out firms that take public companies private; and foreign investors. But the data for this year tend to indicate that virtually every one of these sectors is on strike. If mutual-fund investors refuse to cross the picket lines, the outflows could grow from a trickle into a mighty stream. The market could still go up, but the masses of investors who benefited so much from the rising tide of the 1990s may be left at the water’s edge.