Bond stampede turning mutual fund world on its head

Equity-focused shops in a 30-month streak of investor flight

Aug 29, 2010 @ 12:01 am

By Bloomberg News

Retail investors, burned by two market crashes in a decade, have shunned stocks for the longest stretch in more than 23 years, upsetting the balance of power in the $10.5 trillion mutual fund industry.

Bond funds attracted more money than their equity counterparts for 30 straight months through June, according to the Investment Company Institute. Preliminary data show the trend continued in July, matching the streak posted by bonds from 1984-87.

The shift is pressuring asset managers, especially equity-focused firms such as Janus Capital Group Inc. and The Capital Group Cos., because bond funds charge about 20% less in fees. Among the big winners are bond specialist Pacific Investment Management Co. LLC and firms such as The Vanguard Group Inc. that sell index stock funds, which have become popular alternatives to actively managed portfolios.

“Retail investors are still shocked by what has happened in the past two years,” James Kennedy, chief executive of fund manager T. Rowe Price Group Inc., said last month after releasing second-quarter earnings that fell short of analysts' estimates.

Bond funds attracted $559 billion industrywide in the 30-month period ended June 30, according to the ICI. Investors pulled $209.4 billion from domestic equity funds and $24.4 billion from funds that buy non-U.S. stocks.

Stocks fell 26%, including reinvested dividends, during the period, as tracked by the S&P 500. Bonds returned 16%, based on Bank of America Merrill Lynch index data.

THE CASE FOR STOCKS

Fund companies are trying to lure investors back into equities. Franklin Resources Inc. started a marketing campaign in January with the message that stocks historically do well following a decade in which they lost ground.

“But many investors are turning their backs on equities now — after one of the worst decades the stock market has ever seen,” according to a presentation on the company's website. Franklin manages $603 billion including the Franklin and Templeton funds.

Investors aren't biting. In the first half of this year, 98% of the money that Franklin attracted went into bond funds.

“We are going to keep talking about equities,” chief executive Gregory Johnson said during a July 29 conference call with investors. He said he was concerned that investors were putting “too much” money into bonds, which fall in price when interest rates rise, without realizing the risks involved.

The speed and depth of the market's decline rattled investors in a way past selloffs didn't, and conditioned them to retreat from stocks at the first hint of trouble, said Jim Jessee, president of the U.S. fund business for MFS Investment Management.

In the trading week following May 6, when the Dow Jones Industrial Average briefly lost almost 1,000 points and then recovered, investors pulled $12.3 billion from stock mutual funds, ICI data show. In April, equity funds had deposits of $13.2 billion.

“People have developed a hair-trigger mentality,” Mr. Jessee said. “Their feeling is: "I am not going to be too slow the next time.'”

Amid signs the recovery is slowing, the S&P 500 has fallen nearly 16% from its high for the year on April 23, through last Tuesday. Investor pessimism deepened after the Federal Reserve said Aug. 10 that growth probably will be “more modest.” The central bank said it will maintain its holdings of securities to stop money from draining out of the financial system, its first move to bolster the economy in more than a year.

LITTLE GOOD NEWS

“It is hard to pick up the newspaper and see anyone optimistic,” said Francis Kinniry, who studies investor behavior for Vanguard. “The problem is there is not a lot of good news on the recovery front, and that translates in people's mind into poor capital markets.”

Only one of the 10 best-selling mutual funds in 2010, the $117 billion Vanguard Total Stock Market Index Fund (VTSMX), invests exclusively in stocks, data from research firm Morningstar Inc. show. Its success shows that when investors put money into stocks, they prefer index-based funds over those that are actively managed.

Vanguard, a pioneer in indexed investments, attracted $58 billion in deposits to its stock funds over the 30-month period, the most of any company, according to Morningstar. Over that stretch, U.S. investors put $111 billion more into stock index funds than they took out even as they withdrew $271 billion more from actively managed stock funds than than they put in.

Vanguard, which manages almost $1.3 trillion in mutual funds, has an additional $112 billion in exchange-traded funds, which typically mimic indexes while trading throughout the day like stocks. The firm is owned by investors through their mutual fund holdings.

Investors are using bond funds as a haven from the turmoil in equity markets, squeezing firms previously accustomed to the fatter fees charged by stock funds.

On a dollar-weighted basis, the average stock fund collects 76 cents in fees for every $100 invested, compared with 61 cents for bond funds, according to Lipper Inc.

The impact can be seen in return on equity, a measure of profitability reported by publicly traded asset managers.

At T. Rowe Price Group Inc., ROE fell to 22% in the second quarter of this year from 26% in the fourth quarter of 2007, the last full quarter before the bond-dominance streak began. Stock and blended portfolios accounted for 72%of the company's $391 billion in assets, down from 80%.

Franklin's ROE declined to 19.5% from 26% in the fourth quarter of 2007, as equity funds dropped to 41% of assets, from 59%. ROE at Legg Mason Inc. dropped to 4% in the second quarter from 10% at the end of 2007, while stock funds fell to 24% of its $645 billion of assets from 32%.

“A big part of the problem is that people are still sitting on the sidelines in this market environment,” Legg Mason spokeswoman Mary Athridge wrote in an e-mail.

In the second quarter, the company posted net deposits into stock funds for the first time in more than four years.

Janus Capital Group Inc., with 93% of its $147 billion in assets in stocks, “has probably been hurt the most,” said Jonathan Casteleyn, an analyst for Susquehanna Financial Group LLLP.

Janus earned $61.5 million in the first half of this year, down 27% from year-end 2007. Equity assets fell 28% during the 30-month period ended June 30 as investors pulled $3.9 billion from its stock funds and the decline in stock prices reduced the value of existing holdings.

Janus' return on equity climbed to 12.1% in the second quarter from 5.8% in the fourth quarter of 2007, when earnings were depressed by a write-down of the value of a printing unit. James Aber, a spokesman for the firm, declined to comment.

The rise of the $822 billion ETF business, along with the shift to bonds, has hurt firms with a reputation for active management, including Capital Group and Fidelity Investments, which are both closely held.

American Funds, part of Capital Group, had $48.8 billion in withdrawals from stock funds in the 30-month period ended June 30, more than any other fund firm, Morningstar data show. American Funds has 72% of its $950 billion of assets in stocks and 19% in bonds, Chuck Freadhoff, a spokesman for the firm, wrote in an e-mail.

Fidelity experienced $48.1 billion in withdrawals from its stock funds in the 21/2-year period, the second-most after American Funds, Morningstar data show.

Fidelity said its withdrawals in the period were $32.8 billion, according to an e-mailed statement from spokesman Vincent Loporchio.

Both American Funds and Fidelity have largely ignored ETFs.

In contrast to fund investors, institutions such as pension plans and endowments are increasing their equity holdings, which rose to 68% of assets in July, the highest level in 15 months, a Citigroup Inc. survey showed.

If institutions ignite a sustained run-up in stocks, individual investors will eventually jump back in, said Jack Ablin, who helps manage $55 billion as chief investment officer at Harris Private Bank.

“What will happen is that the market will rally first, and retail investors will chase it later,” he said.

More than 80% of investors polled in July by Fidelity said they wanted to see at least six months of market stability before making further investments.

“Someone who is waiting for stability is likely to miss out on the upside,” said John Sweeney, an executive vice president at Fidelity.

He said that in speaking to clients, the firm stresses the value of diversification and the importance of owning stocks, especially for younger investors who may be 30 or 40 years from retirement. Fidelity has $1.25 trillion in mutual fund assets.

Vanguard's Mr. Kinniry said that the reaction to the 2008 market decline “is different from what we have seen in other bear markets.” Investors have been slower to return to stocks, he said, despite a roughly 60% climb for the S&P 500 since prices reached a 12-year low in March 2009.

The swiftness of the 2008 crash may explain some of the caution, said Mr. Kinniry.

From Sept. 2 to Nov. 20, 2008, the S&P 500 fell 41%, according to data compiled by Bloomberg. Investors were further frightened by the decline in home prices that was already under way, Mr. Kinniry said.

U.S. home prices dropped by almost one-third from July 2006 to April 2009, according to the S&P/Case-Shiller index.

Mr. Jessee said it may take a major market rally to get investors back into stocks.

“Unfortunately, my gut tells me the market will need to go up 30% to 50%,” he said.

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