"Mutual Fund Flows - A Contrary Indicator"

Sydney M. Williams

Thought of the Day

“Mutual Fund Flows – A Contrary Indicator”

May 18, 2010

The fright of “Flash Thursday” on May 6, when the market experienced an intraday drop of nearly a thousand points, crushed investor confidence, spawned Congressional investigations, provided grist for the media and sent investors scurrying from U.S. domestic equity funds into cash.

In March, for the first time since the credit crisis burst on the scene, individual investors – a year into the bull market – put $2.7 billion into domestic equity funds. (In February, they had withdrawn $2.9 billion.) March also closed the best first quarter performance for equity funds (+5.67%) since the first quarter of 2006. Over the past few weeks, money market funds, which experienced redemptions of $223.8 billion in February and March, as the market rallied, saw an inflow of $16.6 billion in the second week of May. As the market swooned, in the past couple of weeks, individuals pulled money from equity accounts. In yesterday’s Wall Street Journal, Kelly Evans, wrote that, “…investors took $2.8 billion out of U.S. stock funds in the week through May 12…the most since March 2009” when the rally began A month earlier the Press had been buzzing with the knowledge that individuals were returning to stocks, after a hiatus of well over a year.

The history of money flows into mutual funds proves individuals’ inability to market time. As the stock market peaked in March 2000, flows into equity funds reached record levels. An article in “Investopedia” (A Forbes company), written by Ryan Barnes, stated that mutual fund flows are a contra indicator. He writes that increasing flows into money market funds can be “seen as a sign the market is undervalued, and vice versa.” Anecdotal evidence supports the case.

Jason Zweig, a Wall Street Journal columnist, in the June 2002 issue of Money Magazine, looked at returns of mutual funds versus actual returns for average investors in those funds. He noted that between 1998-2001 (two bull years and two bear years) the average mutual fund reported a CAGR (compounded annual growth rate) of 5.7%, while the average investor earned 1.0%. Dalbar, Inc., a Boston consulting firm, studied twenty years of returns – 1990-2009 – and found that the average investor earned 3.2% on a CAGR basis, while the average mutual fund generated 8.2%. That may not sound like a big difference, but, on a $100,000 investment, at 8.2% over 20 years, the return would have been $484,000 versus $188,000 at 3.2%.

A mythical story has made the rounds about the Magellan Fund under the tutelage of Peter Lynch. During his fourteen-year tenure (1978-1991), the fund accomplished the incredible feat of compounding returns at 29% – enough to convert a $100,000 investment to $3,500,000. The myth suggests that the average investor in the fund during those years did poorly and many investors lost money. True or not, the lesson is that the individual’s ability to time the market tends to be very poor. As the market peaked in early 2000, high growth funds such as the Janus Twenty continued receiving inflows, while value funds, which would do well over the next couple of years, continued getting redemptions.

It is the business of the media to generate profits; however, in doing so they accentuate the daily emotions resulting from Wall Street activity. Drama and entertainment attract viewers and viewers attract advertisers. And advertisers pay the bills. In doing so, though, a disservice is provided individuals who get caught up in the emotions and momentum of the moment.

Successful investors are, as Seth Klarman wrote twenty years ago in Margin of Safety, unemotional. They analyze a security to determine its worth and then patiently wait for “Mr. Market” to provide a pricing opportunity. Unfortunately (but inevitably) mutual fund flows reflect the contra side of true investors. These people respond emotionally, assuming “Mr. Market” knows something. “The reality”, as Mr. Klarman writes, “is that ‘Mr. Market’ knows nothing, being the collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals.”

Mutual funds manage about $12 trillion, half of which is in equity products. ETFs (exchange traded funds) have begun to take market share and now have close to one trillion dollars. But the same tendencies apply. TrimTabs Research, in a recent study, concluded that there is a strong negative correlation between flows and performance. “Regression analysis,” they write using a double negative, “suggests the probability that equity ETF flows are not a contrary leading indicator is less than 1%.”

Kelly Evans concludes her column in yesterday’s Wall Street Journal: “The long-hoped-for move of individual investors back into stocks was supposed to bring a wave of money off the sidelines. It may take quite awhile before that market prop materializes.” But history suggests, by the time they return, the market will be a lot higher.