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Rekenthaler Report

Who Bought U.S. Stocks After 2008?

Don't look close to home for the answer.

Two Sides of a Trade
In an article entitled "The Fallacy behind Investor versus Fund Returns (and why DALBAR is dead wrong)," investment researcher Michael Edesess questions the notion that mutual fund shareholders and pension funds are similarly poor market-timers. Responds Edesess, "Surely, if one party to a transaction is a bad timer, the counterparty must be a good timer--either consciously or unconsciously."

The sentiment is correct. Investors traded shares Lehman Brothers stock right up until the company's demise on Sept. 15, 2008. For every losing buyer of Lehman shares, there was a winning seller. Securities that are sold don't disappear into the firmament; those that are purchased don't materialize from ether. The market's transactions are symmetrical.

However, Edesess' suggestion that mutual fund owners and pension funds can't be simultaneously wrong goes a step too far. When mutual fund shareholders redeem their investments, thereby causing the funds that they previously owned to sell securities, the buyers of those securities could be pension funds. But they also could be other entities: individual investors, hedge funds, sovereign wealth funds. They might even be corporations, conducting stock-buying programs.

And it certainly does appear that mutual funds and pensions shared the same broad views on U.S. stocks, post-2008.

In Lock Step
Per Morningstar data, after enjoying several years of net sales, U.S. funds (including exchange-traded funds) suffered net redemptions in the four consecutive years of 2009, 2010, 2011, and 2012. During that same time period, the Fortune 1000 corporate pension plans surveyed by Willis Towers Watson cut their average equity exposure from 45.1% to 39.5%.

So we know, without equivocation, that the owners of U.S. mutual funds and the country's major corporate pension funds each had the same reaction to the 2008 market crash: reallocate.

Most likely, that is also what the big U.S. public pensions did. A Pew study shows that the average stock allocation for state pension funds dropped from 61% in 2006 to 50% in 2012. That movement does not prove beyond a shadow of a doubt that the state pensions were net stock sellers from 2009-12, as it's faintly possible that all the cuts occurred in the first three years of that time period, or that the funds were swapping their foreign holdings for domestic stocks in a very big way, but it is strong circumstantial evidence. Almost certainly, state pension funds were also clearing out of U.S. stocks.

That mutual funds, corporate pensions, and private pensions seemed to have behaved similarly after 2008 is unsurprising. All three parties are served by the same cadre of investment consultants, who directly counsel the pensions, and who indirectly counsel mutual fund investors by influencing their financial advisors. In 2009, I attended several investment conferences, some targeting institutions and others targeting advisors. The message was identical: stocks out, alternatives in.

And make no mistake: When viewed from the perspective of the date of this column's writing in July 2016, those were bad trades. There's no way to gild that pig. No matter what stocks were jettisoned and what alternative investments purchased, no matter what the specific trade dates, those deals were a mistake. This column's readers (not you of course, but the next reader over) and pension fund executives collectively cost themselves several hundred billion dollars.

So, who pocketed those gains? Let's go through the candidates.

Hedge Funds--Minimally, at Best
Most hedge funds got the New Era right. They were light on technology stocks as that sector peaked in 2000, making hedge funds among the "smart money" that positioned itself on the correct side of that trade. But they did not follow up that success later in the decade. They were infamously fond of stocks entering 2008, and were certainly not net buyers of equities following that crash, as they were hampered by redemptions and were gun-shy about suffering further losses.

A co-worker suggests that the largest, most secretive hedge funds--those funds that are least likely to report to public databases--bucked the trend by boosting their stock positions after 2008. That may be. However, as giant as they are, those funds lack the bulk to counteract the hundreds of billions of dollars that we know, via the mutual fund and pension records, were exiting U.S. stocks. Even if my co-worker's theory is correct, those funds could only be a few drops in the bucket.

U.S. Households--Probably Not
Despite the boom in funds, households still own a good-sized chunk of the U.S. stock market--enough that they could be the entity on the other side of the trade. That does not seem probable, though, as these by and large are the same investors who were redeeming their U.S. stock-fund assets from 2009 through 2012. It would be unlikely that this move was accompanied by a switch away from the secular trend, back into directly held equities.

From the evidence that I can find, households were indeed cutting back on their directly held stock ownership during that time period. It is indirect, as the report lists only starting and ending median balances, but those balances grew by less than the amount of the stock market's appreciation. It seems that households were not filling the gap that was voided by mutual funds and pensions.

In theory, companies would sell their stock high and buy low by issuing new shares during bull markets and instituting stock buyback programs during bear markets. In practice, that is not necessarily so. Share repurchases--and new issuance--are also related to business conditions. When companies are struggling, they are unlikely to have the case to repurchase shares. They may, in fact, issue new shares, even if prices are relatively low. Conversely, if companies are flush in cash, they often increase share-buyback programs even if stock prices are rich.

Overall, corporations appear to have been a net neutral during the post-2008 period. Their new issuance exceeded their buybacks during 2009 and 2010, meaning that they were net sellers, as were mutual funds and pensions. The next two years, they were net buyers, by roughly the same amount as they had been sellers during the previous two years. A wash.

Foreign Investors--Yes
Ding! We have a winner. Foreign investors bought heavily into U.S. stocks in the aftermath of the crash, increasing their percentage of total-market ownership from 10.1% in June 2009 to 13.9% in June 2012 and 14.5% by June 2013. Four percentage points of change over a short time period means a whole lot of activity--several hundred billions of dollars' worth. Foreign investors not only had the direction right, but they had the mass to be meaningful. They look to have been the party that profited from the post-2008 U.S. stock-market sale.

The big question: Is that because they were smarter than the rest? That is by no means clear. The increase in foreign ownership is a long-term trend, related to the increased globalization of the financial markets. Give credit to those foreign buyers for not wavering after 2008--but not too much credit, because their own markets had declined just as far. If they were to remain invested in equities, they probably were going to boost their U.S. ownership, as they had been previously doing.

Similarly, we should not be too harsh on U.S. mutual fund investors. While they were reducing their U.S. stock-fund positions, they were moving money to overseas markets. They were doing much the same as did the foreign investors, only with less success, as the U.S. stock market outperformed most others.

Alas, the pension funds have no such excuse, as they were cutting equities across the board. They appear to have decided that swapping stocks for alternatives, in the style of Yale's endowment fund, is the better long-term strategy. That may be; the past few years is far too short a time period in which to judge their results. So far, though, that move has not been helpful.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for 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.