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Fund Investors and Managers Go Separate Ways on Stocks

Fund managers are more bullish than fund investors these days.

Kevin McDevitt, CFA, 09/15/2011

Fund investors and managers are forever joined at the hip, but lately they've been running in opposite directions. At least that's the case when it comes to equities--U.S. stocks in particular. In recent years, investors have been selling more of their U.S. equity funds than they've been buying. And while many managers have had to sell stocks in order to meet redemptions, the evidence suggests that most would rather add to their equity positions. This shows up most clearly in traditionally staid allocation (such as balanced) funds, where managers have been incrementally adding to stocks. For investors, that buying is a good gauge of marginal manager sentiment, possibly reassuring contrarian equity investors. For others, this buying should also serve as a know-what-you-own gut reminder. That moderate-allocation fund you own may be more bullish than you thought, for better or worse.

How Times Have Changed
As we and others have noted, individual investors have grown increasingly disdainful toward U.S. equity funds in recent years. Demographics, disappointing performance, and concerns about market integrity have made for a crushing combo of blows to investors' appetite for stocks. Although outflows have accelerated since the credit crisis, investors have actually been pulling money from equity funds for the past five or so years.

As a result of those outflows, along with generally weak returns, equity funds' share of overall mutual fund assets has been declining. In August 2005, U.S.-stock funds alone took up 54% of mutual fund assets (excluding money market funds), while foreign-stock funds absorbed 14%. Meanwhile, taxable-bond funds represented just 15% of overall assets. The landscape has shifted significantly since then. U.S. stock funds' market share has dropped to just 41% of assets, as investors have shifted into taxable-bond funds, which now account for 25% of assets.

Has Cash (As an Indicator) Become Trash?
But just as investors have moved away from stocks, many fund managers have been doing just the opposite. Cash weightings in U.S.-equity funds have declined in recent years, for instance. During the worst of the credit crisis in 2008 and early 2009, average cash balances rose among the nine primary domestic-stock categories to about 4% to 5% of assets. Average cash balances have since dropped by about half, and are now in the 2% to 3% range.

Some market observers take these declining cash balances as evidence of unequivocal equity-manager bullishness. But redemptions have forced some managers to keep less cash on hand than they otherwise would. Fairholme FAIRX manager Bruce Berkowitz, for instance, famously built cash to 25% of his portfolio this past February. Just three months later, its cash stake had fallen below 5%. Some of this decline owed to Berkowitz adding to battered positions such as American International Group AIG, but Berkowitz also had to use cash to meet massive investor redemptions.

This is a far cry from the bubble years in the 1990s, when investors barked at managers for holding anything more than the minimum amounts of cash, which would have been a drag on performance. Back then, some managers felt the need to continue buying shares even after they became uncomfortable with inflated price multiples. This time around, redemptions may be forcing managers to sell stocks when they'd rather be buying.

A Better Weather Vane
In this environment, a more-telling indicator of manager sentiment can perhaps be found among allocation (such as balanced) funds that invest in a mix of stocks, bonds, and other asset classes. In setting their funds' asset mix, allocation managers face some of the same choices individuals make when putting together their portfolios. As with individuals, perhaps their biggest decision is how much of their portfolio to invest in equities versus bonds and cash.

From our recent conversations with allocation managers, the marginal preference is clearly equities over bonds. Although few managers believe that equities look dirt cheap in an absolute sense, most say that, with bond yields so low, equities offer far better value today. Plus, among those who expect the economy to remain sluggish, many believe that cash-rich companies will return money to shareholders through larger dividends, which many see as more enticing than a bond's fixed coupon payment. That's especially true if inflation flares up.PAGEBREAK

The world-allocation category shows managers' equity preference most dramatically. At the March 2009 market low, average equity exposure for these funds was just under half of assets. That weighting has since grown to nearly 57%. One might argue that this increase could simply owe to the subsequent rally; but the average fund's equity weighting was still just 52% in January 2010, after the S&P 500 Index had risen 58%. And with equity markets down so far in 2011, this heavier stock weighting clearly reflects a conscious decision on the part of portfolio managers.

Some of the category's most-prominent funds are leading the way. (Please see the table below.) For example, IVA Worldwide IVWAX manager Charles De Vaulx has taken equities to 69% of assets from 48% in 2009's fourth quarter. Ironically, American Funds Capital Income Builder's CAIBX focus on yield led that fund to increase its equity weighting to an all-time high of 77% in April, as dividend yields tend to be higher than those offered by high-quality bonds. Even longtime bear Rob Arnott, manager of PIMCO All Asset All Authority PAUDX, has become more bullish recently, having more than doubled the fund's equity stake since June to 16% of assets and reduced its position in PIMCO StocksPlus Short Strategy Fund PSPLX.

World-Allocation Funds

At first glance, the average moderate-allocation equity weighting has remained the same since January 2010 (59%), but this is arguably understated. Morningstar created a new allocation category, Aggressive Allocation, in September 2010 to house funds that typically hold 70% to 90% in stocks. Many of the initial 34 funds were pulled from the moderate-allocation category. But their past equity weightings remain included in the moderate-allocation historical averages, which means that the current 59% average is lower than it would have been if those former moderate-allocation funds were included. Besides, the aggressive-allocation category itself has nearly tripled in size in the past 12 months to 97 funds. That alone shows an increasing desire for equities among managers.

Among the remaining moderate-allocation offerings, several funds that we keep a close eye on have been making their own equity push. (Please see the table below.) Weitz Balanced WBALX, for instance, has added incrementally to stock positions while cutting its bond exposure to less than 14% of assets, with 24% in cash as of June 30. Although manager Brad Hinton isn't pounding the table on equities, he believes that, at currently low yields, bonds offer little protection against inflation.

Moderate-Allocation Funds

Mind the Consensus
With many managers turning more bullish on equities, investors who own an allocation fund may want to check its positioning and make sure they are comfortable with it. Meanwhile, those investors who are encouraged by this positive manager sentiment might want to hold a contrarian perspective in mind, too.

Treasury bonds provide a good recent example. Many investors soured on Treasuries after yields spiked last November and December. As concerns grew over the U.S. debt-ceiling debate this spring and summer, buying them seemed like a fool's errand. But there has been no hotter corner of the market this year, as the average long-government fund is up a blistering 24% as yields have plunged. This caught most investors by surprise, including bond king Bill Gross. For investors who see equities as clearly offering better values than bonds, it might be worth consulting a Japanese investor who felt the same way a decade ago. Despite rock-bottom yields, Japanese bonds have roughly doubled the annualized return of Japanese stocks in the past 10 years.

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