Stock Fund Withdrawals Unnerving

Investors are increasingly leaving stock funds for bond funds even though the latter's returns have been meager.
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NEW YORK (

TheStreet

)--For 25 years, fund investors followed a simple pattern. When stocks rose, shareholders put money into equity funds. When stocks dropped, the enthusiasm of shareholders waned, and they often made withdrawals. But the current cycle is definitely different. For a year and a half now, stocks have been rising, and shareholders have been relentlessly pulling money out of stock funds.

The size of the withdrawals is unnerving. Since the beginning of 2008, shareholders have pulled $249 billion out of stock funds, according to the Investment Company Institute (ICI), the mutual fund trade group. To put that in perspective, consider that the previous record outflows came in 2002, a year when the

S&P 500

dropped 22.1% and withdrawals totaled $27.5 billion.

While investors have dumped stocks, they have flooded into bonds, putting $600 billion into bond funds in the last year and a half. The previous record year was 2002, when bond inflows totaled $140 billion.

Why are investors shunning stock funds? Experts offer several theories. Brian Reid, chief economist of the ICI, says that fundamental attitudes of investors are changing. As the baby boomers age, they are becoming more conservative and shifting to bonds.

In addition, Reid says that rough markets of the past decade have played a role in the move toward safer bonds. Investors of all ages now have less appetite to take on risk. Surveying investors in 1998, the ICI found that 30% of fund shareholders under age 35 were willing to take substantial risk. By 2009, only 22% were willing to take risk.

Reid says that the market setbacks have persuaded many investors to diversify stock portfolios by holding some bonds. That represents a change from the environment of the 1990s when aggressive investors ignored advice about diversification and held only stocks.

The trend toward bonds has been encouraged by target-date funds, says Reid. Many of these popular funds invest in a mix of stock and bond funds. With millions of 401(k) investors opting for target-date funds, a big percentage of retirement contributions are pouring into bond funds.

If the current bull market continues, will investors shift gears and begin racing to stock funds? Probably not, says Reid. "We are not likely to see a big move into stock funds any time soon," he says. "People are shifting to bonds because of demographics and new attitudes about risk."

Fund investors are not the only ones moving away from stocks. Corporate pension funds, among the most sophisticated investors, now have 45% of their assets in equities, down from 70% in 2005, according to the Center for Retirement Research of Boston College. The pension funds have made the move in reaction to the market downturns.

When pension assets decline sharply, corporations can be forced to put more money into the retirement plans. That can lower corporate profits. By holding more bonds, pensions hope to stabilize results and make it easier for corporations to develop long-term budgets.

While there may be good reasons to hold fixed income, investors who shift to bonds are likely to get meager returns, says Peng Chen, president of Ibbotson Associates. Chen argues that stocks will outdo bonds in the coming years. "This is not a good period to put money into bonds," he says.

Chen figures that stocks will return at least 5% in the coming decade. To forecast market performance, he starts by looking at the valuation of stocks. The S&P 500 has a price-earnings ratio of 13, around the average historical figure for the benchmark. When stocks are moderately priced, they typically return at least in the mid single digits during the next decade.

To forecast the returns for bond funds, you simply look at the current yield. Because most of the returns from bonds come from the interest payments, the 10-year total return is about equal to the yield at the start of the period.

Chen's system of forecasting bond total returns has proved accurate in the past. In September, 2000, 10-year Treasury bonds yielded 5.8%. During the 10 years that followed, the average intermediate-term bond funds returned 5.9% annually.

The yield on 10-year Treasuries is now 2.65%. So the odds are high that bonds will produce returns of less than 3% in the coming decade. "If you buy bonds now, you are going to be disappointed," says Chen.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.