A mutual fund is a type of investment company that pools money from many investors and invests the money in stocks, bonds, money-market instruments, other securities, or even cash. With nearly $16 trillion in assets, the U.S. mutual fund industry is the largest mutual fund industry in the world at year-end 2014.
Investors in the United States increasingly have diversified their portfolios toward equity mutual funds that invest significantly or primarily in foreign markets (world equity funds). Over the past 10 years, world equity funds received net inflows of $639 billion, while domestic equity mutual funds experienced net outflows totaling $647 billion over the same period. In 2013, this pattern subsided temporarily, and domestic equity funds had their first positive net flow since 2005. In 2014, despite a stronger U.S. dollar, outflows from domestic equity funds resumed: world equity funds received $85 billion of net new cash, while domestic equity funds experienced net redemptions of $60 billion.
In general, net flows into the various mutual fund groups are highly correlated with market performance. The correlations between net flows and market returns range from 12 per cent for government bond funds to 72 per cent for high yield bond funds. In most cases, these correlations can be attributed almost entirely to the unexpected component of net flows. Net inflows to equity funds tend to rise with stock prices, and net outflows tend to occur when stock prices fall.
The return on the MSCI All Country World Total Return Index, a measure of returns (including dividend payments) on global stock markets, was 5 per cent in 2014 and 23 per cent in 2013. At the same time, equity mutual funds received net inflows totaling $25 billion in 2014, down substantially from $160 billion in 2013. Flows to equity funds varied substantially throughout 2014. Equity funds received net inflows of $59 billion in the first four months of the year. As the year progressed, flows waned and turned negative. For example, equity funds experienced net outflows of $24 billion in December.
Net New Cash Flow to Equity Funds
As per Dalbar Studies, which compare the actual performance of mutual funds versus what the average mutual fund investor actually earns, the average investor makes significantly less than what mutual fund performance reports suggest in both stock and bond funds. The problem is not that mutual funds overstate their performance. The problem is that too many investors decide to switch into and out of mutual funds too frequently, in the hopes of boosting their returns. All too often, investors decide to sell the fund(s) they currently own, often at a low point, and switch into the latest hot performers just before they hit a losing period. This practice too often results in selling low and buying high. Because of their excessive annual fees and poor execution, approximately 80% of mutual funds underperform the stock market's returns in a typical year.
In recent years, mutual fund shareholders as a group have not tended to flee from their equity investments when confronted with sharp temporary drops in equity prices. Indeed, there is some evidence that shareholder restraint in requesting redemptions has been greater in the bull period than during earlier periods of market turbulence. This results in the outflow of equity mutual funds even in a bull market much more than that of the outflow of equity mutual fund in a bear market.
Stock fund investors have never redeemed en masse. And their portfolio managers have net liquidated little even in times of large stock market price declines. While flows into long-term mutual funds are correlated with market returns, the flows tend to be moderate as a percentage of assets even during episodes of market turmoil. Several factors may contribute to this phenomenon. One factor is that households own the vast majority of U.S. long-term mutual fund assets, and individual investors generally respond less strongly to market events than do institutional investors. Most notably, households often use mutual funds to save for the long term, such as for college or retirement. Many of these investors make stable contributions through periodic payroll deductions, even during periods of market stress. In addition, many long-term fund shareholders seek the advice of financial advisers, who may provide a steadying influence during market downturns. These factors are amplified by the fact that there are more than 90 million investors in mutual funds. Thus, fund investors are bound to have a wide range of views on market conditions and how best to respond to those conditions to meet their individual goals. As a result, even during months when funds see significant net outflows, some investors continue to make purchases of fund shares.
Overall, the major change for equity mutual funds in an extended period of market uncertainty as in the past will not be overwhelming redemptions, but rather, a decrease in new purchases. But benefiting from steady retirement investing, dollar cost-averaging deposits, and opportunistic buying will prevent equity fund net redemptions from remaining sustained and large.
Reference: Mutual Funds and the U.S. Equity Market
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