Congratulations are in order: Investors are becoming more knowledgeable about mutual funds and are less likely to panic during market downturns.
At least that’s the upshot of a new study by the Investment Company Institute, a Washington-based trade group for the mutual fund industry. The institute analyzed investor behavior from last year’s tough market environment, supplemented that with its own consumer research and concluded that investors are more rational and focused than they’re sometimes given credit for.
The key ramification of these findings is that the stock and bond markets don’t appear to be threatened by the prospect of massive selling by fickle mutual fund shareholders.
Critics worry that if shareholders bailed out in mass during a market selloff, fund managers would be forced to dump more stocks and bonds to meet the redemptions, creating a snowballing spiral that could push prices even lower. Underpinning this fear has been the rapid growth of mutual funds, now worth a collective $2.5 trillion.
The study examined the manner in which shareholders reacted to five temblors that rattled the financial landscape last year. Here’s a recap of those events and the institute’s view of how investors responded:
* Higher interest rates. Long-term rates jumped by about 1.5 percentage points in 1994. The year went down as one of the worst ever for bond investments, which drop in price when rates rise. Bond funds shed 12% of their assets from February, 1994, through March, 1995, but the selling didn’t occur in a short period, as would be the case in a panic. Stock funds, meanwhile, enjoyed heavy cash inflow in 1994--their second-highest year ever.
* Derivative setback in money market fund. As a result of speculations, a fund suffered a loss last year for the first time ever, and two dozen others required subsidies from their sponsors to stay in the black. Yet these events didn’t spark a general run on money market funds, though some troubled portfolios lost assets to more stable competitors.
* The Orange County bankruptcy. The county’s financial failure, also from the misuse of derivatives, could have wreaked havoc on California tax-exempt funds, but the impact was muted, according to the institute.
The cash outflow from California municipal money market funds ceased a couple of weeks after the Dec. 6 bankruptcy filing. California bond funds continued to lose assets for two months, but these shortfalls were in line with setbacks sustained by municipal bond funds generally, suggesting that other factors such as interest rates may also have been at play, the report says.
* The peso collapse. Mexico’s devaluation of its currency in late December, and the subsequent sharp drop in the country’s stock market, hurt the prices of Latin American mutual funds. Yet investors actually channeled more money into these funds over the ensuing six months than they withdrew.
So why didn’t these negatives spark a run on mutual fund assets last year?
One explanation advanced in the ICI’s report involves investor experience. First-time buyers haven’t figured all that prominently in the industry’s growth. According to a separate 1994 study from the ICI, 86% of fund owners had made their initial purchase before 1992. Of the remaining first-time buyers, most reported prior exposure to other risky investments.
A second explanation involves shareholder goals and time horizons. Simply put, many people seem to be hanging on for the long haul, which would imply that they can overlook short-term fluctuations. In the 1994 ICI study, 95% of the investors surveyed viewed their fund holdings as long-term commitments, with retirement ranking as the top goal.
There might be other explanations as well.
Michelle Smith, managing director of the Mutual Fund Education Alliance in Kansas City, Mo., believes that more people understand funds than ever before. But she also concedes that it takes the “mass investor audience” about three months to react to an event. With the tendency for markets to correct in a matter of weeks if not days, it’s possible that prices recover before investors know what hit them.
Paul Merriman of the Merriman Funds, a Seattle group oriented to market timing, doesn’t believe last year’s flat stock market was a sufficient test for most investors.
“A bear market of 20% will freeze a lot of investors,” says Merriman, who notes that prices haven’t posted a drop steeper than that since the crash of October, 1987.
Despite progress made in educating investors, the institute’s study concedes as much. “It may well be that the critical test of shareholder stability has yet to occur,” the report says.