Will the Little Guy Push the Next Panic Button?

One of the hottest topics on Wall Street today would play well as a subject for those cheesy TV tabloid talk shows. They could title it something like this:

“The Small Investor: Innocent Victim--or Evil Perpetrator?”

As the stock market lurches into October, the month’s exaggerated but by now cast-in-stone reputation for trouble has investors of all sizes looking over their shoulders.

In past years, talk of a potential October crash (a la 1987 and 1989) usually focused on the herd instincts of big institutional investors--and typically painted small investors as hapless victims of institutional panics.

Now the question increasingly being asked is whether individuals, through their massive investment in stock mutual funds, could be the driving force of the next crash rather than its innocent dupes.

John Rekenthaler, editor of fund tracker Morningstar Mutual Funds in Chicago, addressed this issue last week in a commentary to Morningstar clients.

He suggested that the historically warm relationship between the press and the funds has become strained recently, as reporters have begun to portray the industry as the proverbial 800-pound gorilla--an entity capable of inflicting great damage.

“Distilled, the case that is being made against funds is as follows,” Rekenthaler writes:

1) Individuals control most fund assets. If the market declines sharply, individuals are far likelier than institutional holders to head for the exits.

2) A crush of small investor “sell” orders to their stock mutual funds would panic today’s young, inexperienced fund managers.

3) Because funds dominate the market, a decision to bail would quickly spur a devastating downward spiral in stock prices because there aren’t enough non-fund buyers to step up and support prices.

Rekenthaler concedes that the sequence of events detailed by fund critics sounds logical enough. But he argues that the first and second points listed above “wither under close scrutiny.” The third point, he says, carries more weight, but still must be viewed in context.

Could individuals spark a crash by bailing out of stock funds en masse? By the numbers, there’s no question that the funds’ sway over the market has mushroomed. Assets of U.S. stock funds total about $600 billion now, up from about $400 billion a year ago, thanks to new investment and rising prices.

Still, at $600 billion, the funds control less than 13% of the $4.6-trillion total value of U.S. stocks, as measured by the Wilshire 5000 index. The rest is in pension funds, private money management firms or direct public holdings.

It’s arguable, however, whether the ease with which investors can enter and exit mutual funds--often with a simple phone call--makes them more susceptible to mass panic attacks than other stock accounts. The real issue, then, is whether fund investors would be any more likely to rush for the exits than other investors.

A recent survey by investment managers Neuberger & Berman suggests that the vast majority of individuals would not panic in a market crash. In fact, more would be buyers than sellers under crash scenarios--or so they say.

As the accompanying table shows, 74% of the survey respondents said they would hold their funds or buy more if the market plummeted 40% in a single month. Only 11% would sell for sure.

The responses are logical, given the market’s recent experience: Since the bull market began in 1982, it has been profitable to buy on every significant market decline, because stock prices have always quickly rebounded.

But some Wall Streeters scoff at surveys that portray a smug confidence on the part of individual investors. With the market at record highs, it’s easy to say you’d be a buyer if prices tumbled 40%.

If such a drop transpired, however, it’s likely that fear would overcome greed and that many people would indeed be panicked.

Rekenthaler doesn’t dispute that idea. He simply doubts that individuals, through the funds, would lead a panic.

So far, he notes, individuals have by and large shown themselves to be patient investors, who--properly--believe they have the luxury of time working for them in their investment plans. That can’t be said of many institutional investors, who are hostage to quarterly performance benchmarks rigidly applied by their big-money clients.

“From the Nifty Fifty (stock) craze of 1973-74 to the torrent of loans made to lesser developed countries in the early ‘80s to portfolio insurance in ‘87, history is rife with examples of rash institutional behavior,” Rekenthaler says. In each case, “a few institutions initiated an idea, the rest piled in, and nearly all of them reversed field when the strategy backfired.”

Yet that indictment of institutions raises the second issue on Rekenthaler’s “anti-fund” list: Fund managers are part of the institutional crowd. It’s entirely possible that in a time of market turmoil, managers could lose control and dump stocks even if their shareholders sat tight.

That fear has been magnified by the belief that most fund managers are novices, because the industry’s asset boom has been a recent phenomenon, dating to 1986.

But Rekenthaler says the inexperience tag is bogus. “The average mutual fund portfolio manager is not some brash young kid a few years out of business school, but is instead 43 years of age and has been in the business for more than a decade,” he says.

Whether that makes them seasoned is debatable. Nonetheless, Rekenthaler’s point is well taken: The fund business isn’t run by a bunch of student interns.

Lastly, there is the issue of the funds’ aggregate power over the markets--and whether there would be anyone left to buy if many of the funds opted to sell.

Though they control less than 13% of the stock market’s value overall, Rekenthaler concedes that in certain sectors of the market--especially emerging growth stocks--the funds’ control and influence is oversized.

At any point in market history, however, some group of investors is almost guaranteed to be dominant over certain securities, Rekenthaler points out. “The implicit assumption that funds are the first entity to achieve such dominance is specious,” he says.

What’s more, there is a strong argument that the increasing globalization of securities markets, while adding to the number of possible market flash points, also assures a wider potential group of buyers for any particular security.

Ultimately, of course, this debate comes full circle: How will individual investors in the funds react to the next market plunge?

Perhaps thankfully, that’s a question only you can answer.

But Will They Do As They Say?

When investment manager Neuberger & Berman asked 501 stock mutual fund owners what they would do with their funds under various market scenarios--bull and bear--here’s how they answered.

If the market Survey respondents would: were to RISE by: Buy Hold Sell Not sure 10% 17% 63% 10% 9% 20% 20% 42% 23% 14% 40% 18% 30% 36% 17%

If the market Survey respondents would: were to FALL by: Buy Hold Sell Not sure 10% 20% 69% 5% 7% 20% 20% 60% 8% 11% 40% 21% 53% 11% 14%

Source: Neuberger & Berman