SI: ‘Resilient’ Fund Flows Set Stage for 2010

According to a new Executive Insight report by Strategic Insight (SI), an Asset International company, mutual funds have shown “remarkable resilience” during 2009, certainly within specific categories.  The report noted that rising new sales and moderating redemptions “imply that net inflows to bond and stock funds, projected to hit an all time record of over $400 billion in 2009, would rise even further next year and possibly eclipse $500 billion, once again led by strong net demand for bond funds (see “Bond Funds Continue Pull on Assets”). 

SI noted that the “massive transfer” of cash to bond funds next year is partly triggered by this year’s 16%+ bond fund average total returns (a number that itself overlooks the impact of significantly higher gains among certain bond sectors), in addition to current yields averaging over 4%. “By the time the US economy recovers enough for the 3-Month T-Bill rate to rise to 2% (which is unlikely before 2011), and thus be somewhat attractive for risk-averse savers, mutual fund investors industrywide will be holding nearly $3 trillion of bond fund assets (nearly double from their level at year-end 2008),” according to the report.   

Bond Bubble? 

That said, SI also cautioned that a slow economic recovery and very slowly rising short-term interest rates suggest that by the time longer-term interest rates start to rise significantly (perhaps in 2011), and longer-duration bond fund net asset values (NAVs) to possibly decline, “safety and income seeking investors will have added $1 trillion-plus to their bond fund portfolios (during 2009-2011).”  A surge that, in the absence of appropriate investor education that helps ease the movement from those vehicles into what SI termed “investments positioned for rising long-term interest rates” and a potentially inflationary environment” could eventually result in another investment “bubble.” 

With about $10 trillion now held in cash in the banking system and in retail money market mutual funds (which are still providing a near-zero yield), and with interest rates likely to remain low during 2010, demand for investments that offer better returns will remain high, according to SI.

Stock Fund Flows 

However, despite the dramatic increase of stock prices in 2009 (50%+ in some cases, albeit again off a severely depressed starting point), new sales of stock funds have remained largely flat.  In fact, SI said that the only notable recent change has been that stock fund redemptions have “slowed in recent months to their normal pre-crisis pace.”  

Noting that it has traditionally taken stock investors 12 to 18 months after a stock market trough to “significantly re-engage,” the SI report said that—possibly—“when short-term interest rates start to increase in 2010, paralleling employment gains, more equity investors will feel it is safe to “go back into the water.”  That said, SI saw “only” a 20% uptick in equity fund sales, though that is coming off of 2009’s depressed pace—with investors still nervous about market risk.  Nonetheless, if realized, that 20% sales increase would translate into over $150 billion flowing into equity funds on a net basis in 2010, according to SI.  

However, U.S. dollar concerns and depreciation have resulted in above average sales increases for international equity and bond funds recently, as well as for multistrategy/strategic income funds, and the SI report said that interest in global diversification should persist in coming years.  “Significant investments in emerging markets in 2009 have lifted security prices in such markets dramatically, in some cases to near or above precrisis levels,” according to the report.  “International equity fund assets account for under 30% of US stock fund investors’ overall portfolios (US-centered funds control the other 70%), and their share could rise steadily in the coming years.”