Going With -- or Against -- Mutual Fund Flows

It's a popular pastime for many investors -- and journalists -- to look at mutual fund flows and use the data to extrapolate what the hot sectors of next year will be.

The problem is, of course, that predictions are never certain, and there's no rule of thumb. One pattern, however, does recur: Fund flows are generally a lagging indicator. By the time the individual investor notices a trend and reallocates his or her portfolio to chase the big returns, that sector is almost always near its high.

"We've found that fund flows lag what's going on in the market," says Scott Cooley, a Morningstar fund analyst. "In 2000, equity funds showed record inflows as the market steadily headed south. And it took people a couple of years of a bear market before they started yanking money out of stocks and putting it in bonds."

Indeed, a Morningstar annual study has nearly always found that the three least popular fund categories (those with the greatest outflows) outperform the top three most popular fund categories (those with the highest inflows) over the next few years.

"The unpopular areas are those that have underperformed and are often ready to bounce back," Cooley says. "The hot areas were usually in areas of the market that were bid up and due for a correction. It's a reversion to the mean."

In other words, the majority of fund investors do little more than chase returns -- and if you bet against the majority of investors, you may find yourself in areas due for a run-up.

Your Best Market Bets for Profit in 2003 The pros say: Look for strength in basic industries and energy (and, maybe, a pickup in tech spending).

The Cheap and Easy Route to Mutual Fund Success Dagen also weighs in on when to sell a stock and why JDS Uniphase will never see 1999 levels again.

Or so you'd like to think.

We'll take a closer look at Morningstar's annual study when it's released later in January. But the bottom line is, there's no surefire, accurate way to predict where the market's heading.

First of all, big outflows don't necessarily mean that bigger outflows aren't still to come.

In measuring outflows, it's tempting to look at them as a percentage of previously existing assets -- in other words, if flows into a sector reach 50% of the assets in that sector a year ago, the sector must be nearing a correction.

But that's not always the case.

"It's like predicting how long a bubble will last -- you won't know until it's over," says Don Cassidy, a senior research analyst at Lipper, a Reuters Company. "There's just no way to say what is 'too hot.' Sometimes [a 10% increase] of a prior year's assets proves to be the top, sometimes the figure is much, much higher."