'Extreme Selling' Punishes Mutual Funds as Investors Buy ETFs

BOSTON ( TheStreet) -- Investors are pulling money from U.S. equity mutual funds as fast as they can as the stock-market decline accelerates. They're buying government bonds, boosting savings and, surprisingly, moving into exchange traded funds.

"Extreme selling" by individual investors has caused $94.7 billion in redemptions from U.S. stock mutual funds in the four months through September, investment-research firm TrimTabs said. For all of 2008, which hosted the financial meltdown, economic recession and stock-market crash, outflows totaled $162 billion.

The wholesale dumping of U.S. equity mutual funds underscores investors' aversion to the stock market's wild volatility. The Dow Jones Industrial Average has had intraday swings of more than 300 points in 20 trading sessions since Aug. 1. A recent survey by Natixis Global Asset Management found 47% of U.S. investors are worried about losing money due to volatility.

The selling isn't contained to U.S. stock funds. Investors also pulled $9 billion from global funds from the start of June until the end of August, which TrimTabs researchers say is the heaviest bleeding in 2 1/2 years. Less than two weeks into this month, October's outflows from global funds total $1.3 billion already.

"Mom and pop are extremely disgusted with international stocks," with "performance probably partly to blame," TrimTabs researchers write in their report released late Wednesday. Global funds have slumped 15.4% this year, more than the 9.6% drop of the average domestic fund.

Morningstar analysts report similar findings, saying September had $6.9 billion flowing out of U.S. stock mutual funds.

So where's the money going? Morningstar notes that $90 billion has flowed into long-term mutual funds this year as $160 billion has flowed out of money market funds. That leaves $70 billion unaccounted for, and builds on a difference of $216 billion from all of 2010.

"With money continuing to flow out of money market funds, a smaller proportion flowing into long-term mutual funds, and bank-deposit growth slowing, it's possible that investors are now using money that used to go into savings for consumption," Morningstar Editorial Director Kevin McDevitt writes in today's research note.

TrimTabs analysts have a different take. They argue that investors are dumping actively managed mutual funds for ETFs, which are easier to trade and offer better tax advantages. As currently constructed, ETFs are subject only to capital-gains taxes when they're sold. Mutual funds, on the other hand, get hit with capital-gains taxes when assets in the fund are sold.

Leon Mirochnik, a research analyst at TrimTabs, calls the widespread dumping of mutual funds for ETFs "the theme of the year." According to TrimTabs' data, U.S. equity mutual funds have net outflows of $73.4 billion, while U.S. equity ETFs have net inflows of $17.3 billion.

In other words, investors would rather rid themselves of a mutual fund manager in favor of trading for themselves. "It's a lot easier for them to do it," Mirochnik says. ETFs are an "industry that is continuing to grow, and the active ETF industry is still a baby."

In September, investors added $4.1 billion to U.S. ETFs, according to Morningstar, a substantial month-over-month increase after inflows of $927 million in August.

"U.S. ETFs have realized only a single month's worth of outflows in the last year," Morningstar ETF analyst Abraham S.H. Bailin writes in a research note today.

Still, there were heavy outflows from the SPDR S&P 500 ( SPY) ETF last month, which bled $2.5 billion alone. That's as the S&P 500 index, upon which the ETF is based, fell about 5%.

TrimTabs notes that the Financial Select SPDR ( XLF) ETF, which is down 20% this year, pulled in $490 million alone in the past week, the third-biggest inflow in TrimTabs' ETF database. That suggests investors are getting bullish on bank shares after they recorded the worst performance among any industry group.

TrimTabs' Mirochnik also notes how smitten mom and pop are with Treasuries. Treasury mutual funds raked in $1.4 billion in the past two weeks, the heaviest inflow of the five major bond fund categories (corporate, foreign, multi-sector and municipal). Treasury ETFs, meanwhile, hauled in $1.9 billion in the past two weeks and $4.2 billion in the past month.

"That's been the investment theme to go along with quantitative easing and Operation Twist," Mirochnik says, referring to the Federal Reserve's support of the bond market to stimulate the economy.

Still, stocks and bonds seem to be stuck between a rock and a hard place.

"If you're an educated investor, you realize you aren't getting a lot from bonds right now," Mirochnik says. "They're trading at record highs and you're not getting a lot of income from them. If you're close to retirement, you almost have no choice but to be stuck with a little risk with really no income. What's the point? From a contrarian perspective, that can't be any more positive for stocks, really."

-- Written by Robert Holmes in Boston.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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