The New Year has started out surprisingly well for equity mutual funds. After years of negative asset flows, both domestic and world equity funds have been experiencing positive flows in 2013. In the first two weeks of January alone, the Investment Company Institute says, domestic equity funds gained $12.75 billion and world equity funds gained $10.9 billion. Inflows have been continuing this month as well.
Is it time for the purveyors of equity mutual funds to rejoice? Is the long drought over? A look at the bigger picture would suggest that celebration is premature. In fact, this mini-trend of positive flows may actually be bad news for the fund industry and anyone else who preaches that serious investors should develop and commit to a long-term investment strategy.
Rather than pursuing a well-thought-out strategy, one can make a strong argument that investors are simply reacting to the current headlines. They are like deer who hear a twig snap in the bushes. They bolt at the first sign of trouble and relax when the noise dies down.
The U.S. stock market just posted its fourth consecutive yearly gain. The S&P 500 Index was up a very solid 16 percent in 2012. This followed a modest gain of 2.1 percent in 2011, another solid gain of 15.1 percent in 2010 and a very strong 26.5 percent gain in 2009. An investor who put $100,000 in the U.S. stock market at the beginning of 2009 had about $172,300 at the end of 2012.
You would think in this environment investors would have been pouring money into the U.S. stock market. We usually chide investors for chasing past performance, but they certainly haven’t been doing that over the past four years. Instead, despite the strong gains in the equity markets, investors have been fleeing equity funds in droves.
Actively managed U.S. stock mutual funds experienced outflows of $134 billion in 2012, making it the worst year ever for such funds. Even worse than the $132 billion outflow in 2008. In fact, U.S. equity funds have experienced significant outflows for each of the past four years.
A number of explanations have been offered to explain this trend. One is that changing demographics are driving aging baby boomers to lighten up on equities as they age. Another is the rapid rise in popularity of exchange-traded funds. No doubt, these are contributing factors. But I believe there is an even more fundamental force at work here.
Fear. Fear of the European debt crisis. Fear of hurtling over the fiscal cliff. Fear that our government has lost its ability to solve our problems. Fear that there is another 2008-like monster hiding under the bed. Fear underscored by wars, theater shootings, school shootings and devastating storms that show us we are not totally in control of our fate.
All this gloom and doom significantly affects our perceptions of the world. In surveys conducted by Franklin Templeton Investments at the end of each year, 66 percent of investors thought the market was down or flat in 2009, 49 percent thought it was down or flat in 2010 and 70 percent thought it was down or flat in 2011. Their moods clearly distorted their realities.
Recently, the winds have shifted a bit. At the last possible moment Congress took action to avoid the worst-case scenarios associated with the fiscal cliff. It even exhibited what looked like a rare flash of cooperation and raised the debt ceiling for a few months to allow time for discussion. The divisive election is behind us and instead of mud-wrestling politicians, headlines featured Michelle Obama’s inaugural gown by Jason Wu. It looks increasingly like the Europeans will find a way to avoid cratering the global economy. President Obama announced an acceleration of troop withdrawals from Afghanistan. The 2008 market meltdown looks smaller in the rearview mirror. And did I mention that equity mutual fund flows turned positive?