Fund Investors Have Been a Steadying Force

In response to Friday’s article, which stated that both fund investors and institutions sold U.S. equities during this year’s second quarter, a reader writes:

Since the turmoil of last spring, friends and I have discussed actions that we took when the equity markets rushed downwards during the month of March. Without exception, we all rebalanced, reducing holdings in cash and bonds and moving those funds into equities. This took place from mid-March through mid-May.

Likewise, my connections in the trust business have confirmed that considerable automated rebalancing took place in portfolios under their care, putting into equities dry-powder cash and some cash from bond redemptions. In addition, advisors offered confirming evidence, in that many clients, instead of heading for the exits out of equities, not only held steady but sensed an opportunity and inquired and then acted on the best approach to invest more in quality equities.

This also was taking place from March through the middle of the second quarter. So, both individual retail investors and investors under the care of trust companies (and presumably in brokerage accounts under the care of RIAs) moved money both automatically and intentionally into equities.

Useful observations. I appreciate the contributions of anecdotal evidence. Back in the day, my colleague Don Phillips gave suggested Morningstar computations “The Steadman-Sequoia Test.” If a proposed measure placed the Steadman family of funds near the bottom of its list and Sequoia SEQUX near the top, then the calculation could proceed to the next step. If not, it needed to be revised. The test worked perfectly. It never failed a valid proposal.

(Shortly thereafter, the SEC destroyed The Steadman-Sequoia Test by shutting down the entire Steadman organization, seemingly under the legal principle of “these funds are too awful to live.” Sequoia’s excellence lasted much longer, for some 25 years, until the fund crashed in 2015; it has yet to recover.)

Asking Why In this instance, however, I do not think the anecdote can overturn the conclusion. Corporations consistently repurchase more shares than they issue. In addition, the Treasury department reports that during second quarter of 2020, foreign investors purchased just over $100 billion worth of U.S. equities. If companies and foreign investors were net buyers of American stock, then others must have been net sellers. Who else but individual investors and/or institutions?

(Admittedly, these effects were not large. With corporations reducing their stock-buyback programs this spring, as they typically do during market downturns--stock-buyback programs almost disappeared in 2009--net inflows into the U.S. stock market were curtailed. Which of course means that net outflows were also modest, as the two amounts must sum to zero.)

Nonetheless, the reader raises a valid point: When interpreting asset flows, one should be very careful drawing conclusions about investor motivations. It’s tempting to believe that the “smart money” supported the U.S. stock market this spring, after equity prices had dropped by one third, while the suckers at the table were the ones who sold. However, those sales could have been made for many reasons, including the sensible and nonemotional practice of rebalancing.

By the Numbers To better understand individual-investor and institutional behavior during 2020, let's look at monthly flows for U.S. equity mutual funds and exchange-traded funds. While registered funds aren't the only ways in which those two groups own stocks, they are a large segment, holding about 30% of all U.S. equity shares. Also, because of their strict reporting requirements, information about public funds is more reliable and up to date than with other marketplace sources.

First, mutual funds.

Such is the picture of a mature industry. Even index mutual funds don’t attract much attention these days, because most index investors buy ETFs instead. Meanwhile, actively run equity funds have long suffered net redemptions. The overall result is net outflows for stock mutual funds, month after month, year after year. The last positive calendar year for U.S. equity mutual fund sales was 2014.

That said, the results do suggest some rebalancing, as the outflows were smaller in April and May, after stocks’ sharp decline, than during the subsequent months. But the amount was exceedingly modest. As U.S. equity mutual funds held $6.8 trillion on April 1, and that month’s net redemptions were $20 billion below the average summer figure, the rebalancing effect (such as it was) accounted for less than 1% of mutual fund equity assets. This after U.S. stocks had lost one third of their value in five weeks.

Onto ETFs.

Aside from November’s sales surge--for which I have no reasonable explanation--the ETF flows have been consistent. If you squint hard, you can see somewhat higher inflows during March and April, but again, these effects were small given the size of the ETF universe. As with mutual funds, the aggregate data for ETFs shows remarkable stability. Anybody who had slept through 2020--what good fortune that would have been!--would struggle to decipher from that chart when stocks tumbled and when they soared.

Conclusion Historically, fund investors have been regarded as among the least stable of stock-market participants. Not only have they frequently chased performance, but because mutual funds have daily liquidity (ETFs, of course, boast even greater availability) and typically do not levy transaction costs, investors in funds can readily indulge their emotions. They can act now and consider the consequences later.

However, they do not appear to have behaved that way. Not only the aggregate figures, as presented in this column, but also the totals for the individual funds suggest that fund investors responded to 2020 largely by doing nothing. Some fund investors rebalanced, as with the initial reader and his acquaintances; some countered those actions by selling when stocks declined and buying when they rebounded; and most, it seems, did nothing at all.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.