By Amey Stone Brutalized by two months of steep market declines and demoralized by negative three-year returns on stock funds, mutual-fund investors seem to be at the end of their rope. This normally stalwart group, whose behavior is seen as a proxy for that of individual investors, actually added to their stock mutual-fund holdings through most of the past year. But in the past few weeks, they've been pulling money out of funds at what may prove a record rate.
Based on preliminary results for July, fund-data service TrimTabs Investment Research predicts a total of $50 billion in outflows (that's the net amount pulled from stock funds after subtracting all the money withdrawn and adding back all the new money invested). TrimTabs bases its estimates on surveys of fund families representing about 15% of all equity-fund assets and admits that its results sometimes vary from the more official, but lagging, cash-flow numbers put out by the Investment Company Institute (ICI), the industry's trade association.
"If this persisted, it would be a record of outflows," says Carl Wittnebert, TrimTabs' director of research. In June, investors pulled $23 billion from equity funds, estimates TrimTabs. The prior record for outflows was $29.5 billion pulled out of equity funds in September, 2001, a direct result of panic following the September 11 attacks.
WAITING FOR CAPITULATION. The heavy rate of withdrawals from funds these days is likely due to investors panicking once again, this time as a result of the barrage of bad news involving illegal and unethical behavior on the part of large corporations. After all, the economy and corporate profits are improving, and the threats of domestic terrorism and global political instability are in a temporary lull.
Wittnebert points to the relatively small amount of withdrawals from international stock funds (just $400 million in June) as evidence that the accounting chicanery and corporate malfeasance on the part of U.S. companies is the real cause for current selling. Not surprisingly, the categories of stock funds experiencing the highest redemptions are those that have suffered the steepest losses, including aggressive growth funds and technology funds, according to a July 5 fund report put out by the Federal Reserve Bank of Boston.
The great irony of the spate of recent stock-fund redemptions is that many investment strategists see this as a positive sign for the overall health of the stock market. That's because they've been waiting for weeks for what they term "capitulation" -- the phase in a bear market where the last holdouts finally throw in the towel and sell their stocks. That low point, signaled by more brutal declines, sets a foundation from which stocks can begin to recover.
MARKET TEMPTATIONS. "We're not saying when -- it might be in the next two weeks or even a month or so -- but the current exodus from investing is a sign that this bear market is probably coming to a close," says Milton Ezrati, senior economist and strategist at investment firm Lord Abbett & Co. He believes economic and company fundamentals don't justify the downturn in the markets, which means the market has reason to recover once the current round of selling subsides.
"What has been going on has been a typical bear market response," says Thomas McManus, chief investment strategist at Banc of America Securities. "It's too bad," he says, since investors are so often lulled into selling at the bottom and investing more at the top.
McManus' research suggests that the net redemptions of the past few weeks reflect retirees pulling out more money than usual and young investors putting in less than they would otherwise. He worries that young people exiting the market now could be making a big mistake, since they may not be able to save enough for retirement. "The market is always tempting you to make the wrong decisions," he says. "It looks really good when it's the wrong time to buy and really bad when it's the right time to buy."
NOT DOOMSDAY YET. Investment strategists and fund experts agree that even $50 billion in redemptions in July (if it gets to that point) wouldn't be reason to worry about the health of the mutual-fund industry. As of the end of May, a total of $3.3 trillion was invested in stock funds, so $50 billion would be just 1.5% of the total. Notes Wittnebert: "It's not like everyone is rushing for the exits all at once."
Plus, according to ICI, a total of 5.1% of all assets invested in stock mutual funds is in cash (about the same level as a year ago), so the need to meet redemptions shouldn't force the great majority of funds to sell stocks. Doomsday scenarios have long suggested that individual investors would cash in their funds en masse in a bear market, triggering extra-steep declines as fund managers were forced to sell stocks to meet redemptions. The industry is nowhere near that level now.
In fact, the heavy U.S. stock-fund redemptions are a fairly recent phenomenon. The ICI's most recent tally (covering activity through the end of May) shows that investors added $72 billion to stock funds in the first five months of the year. And the annual rate of redemptions from stock funds in May, 2002, was about the same as May, 2001 -- a little more than 24% of total assets.
THE BIG SHAKE. That's why McManus is waiting to see if the redemptions pick up speed before he decides this is the long-awaited capitulation and raises his equity allocation. For now, he's recommending only a 55% allocation in equities, but he says he's inclined to raise it.
"Capitulation has to fit the size of the crime," says McManus. "We'll wait until we see that stocks are attractively priced and we see signs that some of the investors who came in at the wrong time are shaken out." If mutual-fund trends seen so far in July persist, that may final shaking out may be well under way. Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column