Mutual funds: Where the smart money is
Corrections and clarifications: An earlier version of this column misstated the publication that proclaimed the "death of equities." It was Business Week, not Barron's.
One of the enduring myths in investing is that small investors are nimrods, lovably and haplessly doing the wrong thing at the wrong time. All you have to do to be a savvy contrarian is to do the opposite of what those dumb small investors are doing.
At first glance, anyway, one of the things that those silly individuals have been doing is selling U.S. stock funds — and in the middle of a rip-snorting bull market. This year alone, investors have sold $39.1 billion in U.S. stock funds. A contrarian might reason that since the foolish smaller investor has been selling stock funds, the bull market has a long way to run.
But there are plenty of things wrong with that reasoning, and it's worth taking the time to deconstruct it. Investors have, indeed, been shifting money around. But the causes of those shifts are not easily interpreted, and certainly not the way that contrarians might think.
Let's start with contrarianism. A contrarian is not just someone who does the opposite of what the herd on the Street does. You'd have more fun with your money by making paper airplanes out of $100 bills and throwing them off the Empire State building.
Most times, the crowd is right. If you had decided to bet against the market five years ago because – listen up, sheeple! – everyone was wrong about the Fed, the Treasury, the party in power, Taylor Swift – you would have been clobbered. A trend-following approach can be very successful for long periods of time.
Until, of course, the market turns. And contrarianism is based on perceiving those inflection points – moments of maximum optimism or pessimism. The problem is that finding these points can be exceptionally difficult, and those who want to seem particularly clever like to look for things that are obvious only to them.
For example, USA TODAY ran a bull on its cover on May 29, 2013, along with, well, a bullish story about the market. Aha! A bull on the cover of a mass-market publication! That must be the end of the bull market!
Well, no, even though mass-market publications do have an unfortunate tendency to overplay the stock market at the wrong time. (Business Week, notably, proclaimed "The Death of Equities" in August 1982.) Nevertheless, the Standard and Poor's 500 stock index is up 25% since USA TODAY's cover.
The problem with these kinds of reed-thin indicators – newspaper stories, hemlines, advertisements – is that one probably isn't enough. You need quite a bit of evidence of frothiness, and frothiness can last a long time, as anyone who lived through the 1990s can tell you.
The use of mutual fund flows as a stock market indicator is particularly tricky. For example, let's dolly back to Dec. 31, 2008. The stock market was down 42% from its October 9, 2007, high. Investors had yanked nearly a quarter-trillion dollars from stock mutual funds over that period. Those silly fund investors were capitulating! Time to buy, right?
Well, not quite. From Dec. 31, 2008, to March 9, 2009, when the bear market finally ended, the S&P 500 fell another 25%. You would have been close to buying at the bottom – better than buying near the top – but a 25% loss is still painful.
The notion that mutual fund flows are good contrary indicators starts, of course, with the belief that small investors are idiots. Funds were designed for those investors who didn't have the money or skill to construct stock portfolios.
In fact, most individuals – those who have enough money to invest, anyway – are remarkably sober investors. Currently, investors own $15.8 trillion in open-ended funds –the most common types of funds that are priced once a day and most likely to be found in a 401(k) plan. About 53% of that is in stock funds, 22% in bond funds and 17% in money market funds. The rest is in hybrid funds, such as balanced and target retirement funds, which are a mix of stocks, bonds and money market securities.
The overall mix of mutual fund assets is fairly conservative, and certainly not the type you'd expect to see at the top of a multiyear bull market. What's particularly interesting, though, is the steady redemption of U.S. stock funds that we mentioned earlier.
Part of the reason for the move out of U.S. stock funds is the rise of exchange-traded funds, which you can trade all day on the stock exchanges, just as you would Apple or General Motors. Through August, investors have put about $35 billion into U.S. stock ETFs, according to the Investment Company Institute, the funds' trade group.
Rather than pouring money into U.S. stocks, investors have been putting money into international stock funds – a puzzling move, given the generally wretched performance of foreign stocks this year. The MSCI Europe, Australasia and Far East Index has fallen about 2.4% this year, including reinvested dividends, vs. a 13.9% gain for the Standard and Poor's 500 stock index. Investors have poured $88.8 billion into international funds, the ICI estimates.
What gives? One logical solution is that most individuals buy their funds through advisers, and advisers generally recommend you keep 20% to 30% of your stock assets in international funds for diversification purposes. In 2000, just 8.6% of mutual funds were in world stock funds, says Brian Reid, chief economist for the ICI. Today, it's about 26%. Throw in ETFs, and the total is about 29% of all mutual fund assets.
Whether this is good advice or not remains to be seen. Most major world markets are certainly less expensive, relative to earnings, than the U.S. market. On the other hand, they generally are, and adding international funds to your portfolio also injects currency risk.
The other big trend advisers are likely responsible for: the popularity of low-cost index funds. One of the biggest losers in the mutual fund world has been actively managed, fee-laden funds. Advisers prefer low-cost funds because they're a smart choice, and because the funds' low fees make the advisers' fees more palatable. Sponsors of 401(k) plans also prefer low-cost funds, in part because they're worried that investors will sue them for not choosing the least expensive funds.
So how good an indicator are mutual fund flows? Not terribly. And given that brokers and advisers control the bulk of mutual fund flows, you should raise an eyebrow whenever you hear anyone from Wall Street pointing to fund investors as the dumb money. If you believe that the majority of investors are wrong at the top of the market, the majority of money is controlled by the pros – and those are the ones you should worry about. (Did you sell in the middle of the flash crash? Of course not. It was almost entirely institutional selling.)
Right now, the smart money seems to be adding money on a regular basis to a conservative allocation of low-cost mutual funds. Hard to see anything dumb about that.