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.
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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
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."
Outflows also prove to be a lagging indicator. Once a sector gets so bad that individuals start exiting in droves, it usually leads to an area of the market that gets oversold.
That also explains why outflows as a percentage of assets can be misleading. Take the technology industry, for example. In 2002, technology outflows were a mere 10% of December 2001's asset base of $66 billion, Cassidy says. "But the value of tech funds have halved as well," he notes. "So it's really more than $6 billion in outflows based on assets of $30 billion or so."
In other words, technology fund outflows are greater than the percentage of last year's assets would indicate.
Still, fund flows do reflect investor sentiment. And that sentiment is moving tentatively towards equity investing again.
Stock funds had an inflow of $6.46 billion in November, according to the Investment Company Institute. Not bad, considering the $7.5 billion outflows of October. Through November, though, stock funds have seen a net outflow of $19.87 billion, or 0.7% of average assets. The last full year during which stock funds had net outflows was 1988, when 8% of assets flowed out.