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Jewish World Review Nov. 11, 2008 / 13 Mar-Cheshvan 5769 Mutual funds can get caught in downward spiral By Gail Marks Jarvis
http://www.JewishWorldReview.com | (MCT) Traumatized investors are fleeing mutual funds in huge numbers - grabbing what remains of their money and putting it anywhere that doesn't leave a knot in their stomach. Although the most dramatic lurch for the exits might be over, history suggests that people could be yanking money from mutual funds for years. If true, the trend could hurt people who remain invested in mutual funds, as well as some who took the money and ran. After the 48 percent decline in the stock market in 1973 and 1974, people pulled money out of mutual funds until 1980, even though the market moved higher. "They used the strength in the market to get out," said Eric Bjorgen, who tracked the trend for the Leuthold Group, a Minneapolis-based research firm. "Many never came back into the market then or after the 2000 bear market." "Once bitten, twice shy," Bjorgen said. With the market plunging in October, many individuals fled after losing nearly half of the money they'd had about a year earlier. This year, investors have pulled roughly $200 billion out of U.S. and international stock mutual funds - a huge reversal from the $254 billion they poured into funds the previous two years, said David Santschi, TrimTabs managing editor. Although selling shares in losing funds can be smart for those who plan to declare a loss on their taxes, many people have shifted money into saving accounts and money market funds. The low-interest investments aren't likely to allow them to regain what they have lost for decades. And some have committed expensive mistakes, such as pulling money completely from 401(k) plans without realizing they owe taxes and penalties that could strip almost half of their savings. While those remaining in mutual funds probably will receive the advantage, eventually, of a surge in the stock market, some are in funds that will face an uphill battle. That's because the stock-pickers managing their funds are limited now in the bargain hunting they can do for cheap shares. It's a result of so many investors fleeing funds. When a person wants to leave a fund, it must have cash available to give the investor. But most mutual funds tend to hold little cash. So as investors demand their money, mutual fund managers are being forced to raise cash by selling stocks they wouldn't otherwise sell, said Morningstar Inc. analyst Karen Dolan. "A fund facing redemptions is restricted in its flexibility to do much," she said. Selling shares that have potential to climb eliminates some opportunity for funds to make money when the stocks regain strength. In addition, respected investors such as Warren Buffett contend bargains are plentiful now, but fund managers who are busy raising cash might not have money available to bargain-hunt. That will dampen the returns a fund can make in the future. Great sums of money can be made by picking solid stocks beaten down in bear markets. On average, during the first year following the low point in a bear market, the stock market climbs 44 percent, according to the Leuthold Group. By the second year, on average they are up 60 percent from their lows. At the end of October, the Standard & Poor's 500 index had fallen about 46 percent from its peak. Tremendous redemptions can be life-threatening for some mutual funds. "At its worst case, depending on the liquidity of holdings in the portfolio, redemptions can trigger a vicious cycle that can really drive down a fund's value," Dolan said. The cycle plays out like this: Investors become nervous about bad returns and decide to leave; then the fund must sell more of its stocks or bonds at low prices to raise cash. As the fund managers do this, they accept low prices for the securities and incur costs for trading stocks and bonds. Consequently, individuals with money in mutual funds see their returns lag other investments such as index funds, which don't actively pick stocks, or the stock market in general, and more people decide to leave the fund. Although the cycle could stifle returns in any fund, typically there would not be a serious downward cycle in big mutual funds that invest in large-company stocks. Such stocks can be sold fairly easily, even in a rough stock market. But this year the worst-case scenario has been obvious in bond funds such as Schwab YieldPlus and Fidelity Ultra Short Bond - two funds that sank after investing in bonds that could not be easily sold as they faced huge redemptions. This year, some of the nation's most respected stock fund managers have faced large redemptions as early bargain hunting failed to produce sizable returns. Funds with extraordinary long-term records such as Dodge and Cox, Longleaf Partners and Third Avenue Value have had to deal with disappointed investors. Every weekday JewishWorldReview.com publishes what many in the media and Washington consider "must-reading". Sign up for the daily JWR update. It's free. Just click here. Gail Marks Jarvis is a personal finance columnist for the Chicago Tribune and author of "Saving for Retirement without Living Like a Pauper or Winning the Lottery." Comment by clicking here.
10/27/08: Investors can bounce back from even the worst of times
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