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Have we lost something by having managers stay fully invested? I don't think so. In order for strategic cash to be a useful tool, a fund should meet two tests:
- The manager should be good at using cash as a macro call or as a reflection of opportunities the manager is finding, as you see at places such as Longleaf, Fairholme and First Pacific Advisors.
- It should be clear to shareholders that the fund will make such moves into cash. Not many funds meet those criteria. I have no problem with those that do; it's hard to argue with Longleaf's approach or results, for example.
Moreover, funds stay fully invested because advisers can do a much better job of allocating cash for their clients than managers can. Advisers can design allocations that suit their clients.
In addition, cash in a money market fund is readily accessible in case of emergency or the need for a big purchase, whereas you can't exactly tap cash in a stock fund. It could be way down when you need that cash, or it could be way up, meaning you'd have to pay taxes if you redeemed.
Fund flows tell you where you've been
What about fund flows? Unfortunately, fund flows are a lagging indicator. Want to know where the market has been the past two or three years? Great, then flows are your answer.Let's go back to the beginning and end of the bear market of 2000-02 to see what happened:
- In 2000, when the bubble burst, we saw massive inflows of $388 billion as a strong economy and a wacky market sustained investment even as the market moved lower.
- In 2001, inflows surged to an all-time record of $504 billion. There was a general expectation that the economy and the markets would rebound -- until the attacks of Sept. 11, when that changed dramatically.
- In 2002, net inflows dipped to $74 billion, though that would have been the best time to buy.
- In 2003, when the markets snapped back brilliantly, funds suffered net redemptions of $43 billion.
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In short, flows might work as a nice contrary indicator, but they certainly don't drive the market or predict where it's headed. Though the trend partly reflects a sorry inclination to chase performance, it also simply reflects how much money people have to invest. After all, the bear market overlapped with a recession, and investors just had less to invest, too.
As we appear to now be in a recession, I'd expect flows into mutual funds to grind lower for the rest of the year. I've got no idea what that means for the market, though.
This article was researched and written for Morningstar by Russel Kinnel.
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