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By Christine Benz | 11-09-2011 12:00 AM

Stock Investors Take Chips Off the Table in October

Despite equity markets having one of the best Octobers in recent history, U.S. stock funds continue to see robust outflows that could eclipse what we saw in 2008, says Morningstar's Kevin McDevitt.

Christine Benz: Hi. I'm Christine Benz for Morningstar.

Stocks had one of their best months in October in nearly a decade, but that didn't stop investors from yanking money from equity mutual funds.

On the phone with me to discuss the latest trends in fund flow data is Kevin McDevitt. He is editorial director for Morningstar.

Kevin, thank you so much for joining me.

Kevin McDevitt: Thanks for having me, Christine.

Benz: I guess the headline here, Kevin, is that equity mutual funds really did continue to see outflows in October, even though it was a very strong equity market. What do you think is going on there?

McDevitt: I think there are a couple of things at work. One is, it's just a continuation of the recent trend. This is the sixth consecutive month of outflows for U.S. stock funds. We've also tended to see a bit of seasonality, which we can talk more about. The second half of the year, you tend to see more selling in general for equity funds over the last five years or so. Then I think, also, there is somewhat of a lag effect. As you mentioned, we had a great rally in October, but that was coming off of a pretty sharp fall in September. I think very often there is somewhat of a lag between when investors act and what is happening in the market day-to-day.

Benz: One thing that kind of confounds me, Kevin, is that you say that outflows could actually eclipse what we saw in 2008, which is stunning, given 2008 with such a wrenching bear market. 2011 has not been great, but it's certainly not been anything close to that. What do you think is driving investor sentiment to be so negative?

McDevitt: I think it goes back to some of the things we have talked about in the past, about just how sensitive investors are these days, and how risk-averse they are, and how quickly, I think, they are to take their chips off the table or at least try and reduce risk in their portfolios. So I think it's a combination of things.

I also think ... if you're looking for things to be worried about, there are certainly plenty out there, just between what could happen in terms of economic growth in this country. People are still talking about a possible double-dip recession, and you have all of the concerns in Europe with the sovereign debt crisis. So there is plenty to be concerned about. Then, on top of that, I think it's just the trends we've been seeing, again, with sentiment being fairly negative for the last six months or so. I don't think it takes much to get investors to do more selling.

Benz: One trend we've be monitoring, Kevin, is this trend of flows into passively managed equity funds. So even though investors were yanking money from stock funds overall, were they sending it to the index funds?

McDevitt: Well, this past month, this is the exception. They actually pulled money from U.S. stock index funds. They pulled about $3.5 billion out of U.S. stock index funds, and that's really somewhat of a surprise. It's only the third month over the last three years in which we have seen more than $1.5 billion come out of U.S. stock index funds.

Over the last three years, as we have talked about in the past, you've had about $68 billion in inflows into U.S. stock index funds, as opposed to the massive outflows we've seen out of U.S. stock funds generally. So, maybe this is an indication of how negative sentiment was in October--the fact that you did see fairly robust outflows out of index funds.

Benz: So, broad-based selling.

I want to shift gears, Kevin, and talk about what you see in terms of the international stock fund flow picture. You mentioned Europe. It's been a big overhang on developed foreign markets. What are you seeing in terms of the trends in fund flows there?

McDevitt: There are a couple of interesting things. One of the strongest themes is how, I guess, how patient U.S. investors have been with international funds and international markets in general, and emerging markets in particular. Emerging markets have had a really rough year in terms of performance. They have fared far worse than domestic equity funds have. The average emerging-market fund is down about 14% for the year-to-date through October, and that's far worse than the average domestic equity fund, which is flat to roughly down a bit through October. But still, investors sent another $2.1 billion or so to emerging-market equity funds.

We haven't seen quite as much enthusiasm for developed-market funds. Investors have pulled some money from the developed-market, traditional foreign stock funds, large-cap foreign stock funds. But even there, even though they have also performed far worse than domestic-equity funds, outflows have not been nearly as severe as they have been on the domestic side, which is, again, I think somewhat surprising, considering how you do have the sovereign debt crisis. If you look for where the real trouble spots are these days, it's overseas, not in the U.S.

Benz: I want to follow up on the point of about emerging markets, Kevin. You mentioned performance has not been good there--in fact, some of those categories in emerging markets have been among the worst performers year-to-date. What do you think investors are latching on to? Is it just the prospect of potentially higher growth over the years in those markets versus what they can get in the U.S. and developed foreign markets?

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