Are Stock Funds Attracting Too Much Money?

Generally speaking, bull markets don't end in silence. They end loudly and visibly, after the successful asset class receives an influx of new assets. Many regard mutual fund cash flows as a version of the canary in the coal mine--the indicator that suggests a future problem. Unlike the feathered canary, however, who suffocates to send its signal, the fund canary collapses from gluttony. Fund categories that attract a high amount of new investor monies, as indicated by net sales (that is, gross sales minus redemptions) are fund categories that may be overbought and, therefore, ripe for a fall.

That pattern has held pretty well for U.S. stocks over the past 15 years. In the late 1990s through 2000, U.S. stock funds enjoyed their highest inflows ever, at the S&P 500's top; they retreated into redemptions in 2002, at the market bottom; they recovered to enjoy positive inflows until the 2008 crash; and they suffered consistent outflows from 2009-12. An investor who used one year's information about U.S. stock fund cash flows to influence the next year's asset allocation, cutting back on stocks if inflows had been strong and adding to stocks if equity funds had suffered outflows, would have fared nicely over the past 15 years, aside from being too cautious in the middle part of that stretch.

So, the 2013 cash flows are of some interest. They are, however, rather difficult to interpret.

The Wall Street Journal took a crack at the subject in late December, with an article titled, "Stock Rally Fails to Spur Big Inflows Into Mutual Funds." (Subscription required.) The headline gives away the punch line: The data used by the Journal show 2013 inflows into U.S. stock mutual funds to be a relatively modest $60 billion. While a positive figure, that's not much in the grand scheme of things, as several years during the 1990s U.S. stock funds gathered more than $100 billion. Moreover, as the article points out, U.S. stock funds had shed $450 billion in cash outflows over the previous seven years, so $60 billion looks to be just the beginning of the process.

So far, so good for U.S. stock owners. The problem is, whereas mutual funds once accounted for almost all fund flows, they are now only part of the story because of the growth of exchange-traded funds. Also, sector funds at the least, and international-stock funds at the most, are relevant to the analysis.

Incorporating ETFs, sector funds, and international-stock funds gives a very different view. Courtesy of Morningstar's Michael Rawson--

  - source: Morningstar Analysts

Now that's a different picture. Per this view, stock fund sales broke all records in 2013, dramatically trumping the previous high of 2000, which coincided with the peak of a long bull market. That chart suggests utmost caution.

Let's look at the inflows in more detail--

  - source: Morningstar Analysts

Beginning with $58 billion in U.S. diversified stock fund sales, another $98 billion must be added from ETF sales. After all, whether in ETFs or mutual funds, an inflow into a diversified U.S. stock fund is an inflow into a diversified U.S. stock fund. Then comes $70 billion into sector funds. Including this amount is a bit dicier, as sector funds often invest globally, but for the most part it belongs on the U.S. stock ledger. The initial $58 billion (or $60 billion in the Journal's story, which uses a different data source) has swollen to almost $230 billion.

Such a figure restores 2013 to being a very large sales year for U.S. stock funds, the biggest save for 2000. 

The year becomes the biggest ever if the sales of international-stock funds are counted. Doing so would seem to be an odd decision. After all, non-U.S. companies are not U.S. companies, and the purpose of this exercise is to gauge whether U.S. stocks are overbought. If cash flows into funds directly indicate the extent to which prices have been pushed up, and the extent to which most buyers have already entered the market and relatively few remain, then the fate of international-stock funds is beside the point.

However, it's not clear that the signal works so directly. In truth, there's little theory behind the mutual fund cash-flow canary, just a general notion that somehow, in some way, too much eventually becomes too much. Perhaps sales of international stocks do count, because they contribute toward what really matters: the risk appetite of U.S. fund owners. If total stock fund sales is the measure, then 2013 was a record year, surpassing even 2000. Last year, more new fund money went into equities than ever before. The risk-on/risk-off trade was definitely on.

Thus, the data suggest that 2013 stock fund inflows were: 1) comfortably modest; 2) worrisomely large; or 3) dangerously high.

Muddling the waters further has been the behavior of institutional investors. Whereas institutional buyers echoed fund shareholders in selling off U.S. stocks during the second half of 2011 and all of 2012, they did not jump back into equities in 2013. Per a December article from FundFire (no link to the article, which is paywalled), institutional investors sold a net $45 billion of U.S. stocks in the first half of 2013, followed that up with $63 billion more of outflows in the third quarter, and continued to sell during the fourth quarter. Thus, institutional net sales of U.S. equities in 2013 look to be more than $150 billion--roughly two thirds of fund inflows.

In short, to address this column's headline question, stock funds probably have not attracted too much money. They have attracted a large sum by most measurements, but the past few years' fund redemptions and the counterbalancing trades of institutional investors weaken the contrarian signal. The canary looks to be full but not stuffed.

John Rekenthaler 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.