Money Pouring Into Mutual Funds

The industry's scandal fails to scare away investors, despite comparisons to the stock bubble.
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For some stock watchers, mutual fund inflows this year have brought back memories of the stock market bubble three years ago.

The scandalous behavior of some of the nation's biggest mutual funds and a well-publicized investigation by New York Attorney General Eliot Spitzer have done nothing to deter investors from plowing money into mutual funds this year.

In September alone, equity funds saw net inflows of $17.3 billion, with $16.9 billion of that going into domestic funds, according to the Investment Company Institute. It is the sixth straight month of net equity inflows greater than $10 billion -- something not seen since 2000.

"I think we're in a mania," said Alan Newman, editor of the financial newsletter

Cross Currents

. "I would think a lot of the inflows that you're seeing are from pension funds, not necessarily individuals, and it's going to end poorly, the same way the first bubble ended."

Inflows into growth funds have outpaced inflows to nongrowth funds for the third month in a row, while fund flows compared with total assets are now sitting at levels comparable to those of 1999, according to Merrill Lynch.

Still, there is evidence that things might be different this time round. Although inflows into growth funds have hit $42 billion so far this year, inflows into nongrowth funds have hit $46 billion. At the equivalent point in 1999, growth inflows totaled $99 billion, more than twice the amount that went into nongrowth funds, Merrill's global strategist David Bowers noted.

Meanwhile, investors seem to be much less obsessed with technology than they once were. At the height of the bubble, technology funds had massive inflows. Today, investors are more interested in small-cap and value funds, Bowers said.

Smith Barney analyst Tobias Levkovich points out that September's mutual fund inflows were well below the $53.55 billion recorded in February 2000. So far this year, some $97.5 billion has channeled into mutual funds, down sharply from the $272 billion that flowed into funds in the first nine months of 2000.

Investors are also much less interested in overseas funds today than they were in 2000. Back then, inflows were strongly in favor of global and international funds, but overall activity in these funds fell in September to the lowest level since 1991.

Of course, this isn't necessarily a positive development. Investors didn't actually need to invest abroad during the 1990s, because returns in the U.S. market were so superior. But analysts don't expect the U.S. to repeat that performance going forward, and they believe investors should diversify their portfolios to capture growth abroad. "It seems equities are back in the grace and favor of the U.S. investor -- as long as the equities are domestic," Bowers said in a research note.

It's not surprising that analysts have started to compare today's environment to the bubble period of late 1999 and early 2000. The

Nasdaq

has jumped 48% since the start of the year, and many poor-quality stocks have tripled in value.

"Particularly in cyclical sectors like tech, we are seeing companies with heightened valuations that could crumble if they aren't able to beat heightened expectations," said Seth Scholar, senior research analyst at Sand Hill Advisors.

Cross Currents' Newman said while stocks aren't as overvalued now as they were in 2000, "they're overvalued enough so that, in my humble opinion, they're not going to make any money in the next five years."

Levkovich believes there are pockets of speculation, particularly in biotech and telecom equipment stocks, but he said fears of a stock market bubble are "exaggerated."

"In our view, speculative investment behavior is usually accompanied by widespread complacency, not continued caution," he said, noting that short interest on the

Nasdaq

rose to a record high last month. "We do not see the same bubble-like attitudes, valuations or money flows in today's markets that were the rage of the late 1990s."

Levkovich said the bursting of the tech bubble didn't put a stop to innovation. He thinks businesses could begin to deploy wireless systems in 2005, and that could create a new wave of capital spending. That said, Levkovich expects tech stock outperformance to end next year, as stronger economic growth leads to higher interest rates. "We need to see fundamental reasons for turning negative rather than just relying on fears of a bubble echo," he said.