Mutual Fund Flows a Bad Indicator of Investor Sentiment

Wall Street analysts often make predictions and argue whether the bond and stock markets will be bearish or bullish based on the flow of money in and out of mutual funds.

On the face of it, that approach makes sense. Analysts reason that "unsophisticated" individual investors, the primary holders of mutual funds, take their money out of the sector of the market that is performing poorly, say bond funds, and put it into the sector of the market that is performing well, say stock funds. When individual investors get into the market, they will buoy prices for a time, only to have the "smart" (read institutional investors) money take profits and get out of that sector, or so the analysts reason.

Seems like a pretty logical concept. But logic in financial markets can often be wrong, according to a recent study. Vincent Warther, a professor of business at the University of Michigan, found that looking at the flow of money in and out of mutual funds is fairly useless as a gauge of investor sentiment.

Professor Warther found that while investors did care about the individual performance of their funds, "there is no evidence that investors move into the stock or bond markets in response to recent stock or bond returns at quarterly or annual frequencies."

Professor Warther also found that there "is no evidence for price pressure, nor support for the belief sometimes expressed in the popular press that large inflows into mutual funds are a signal for smart money to get out of the market."

Wall Street analysts also look to whether closed-end mutual funds are trading at a discount or premium to their net asset value as an indicator of individual investor sentiment. Although quite similar in nature, closed-end funds issue stock once as opposed to mutual funds, which continually issue new stock. When investors get bearish they often sell their closed-end funds, pushing their prices below their net asset value, or the actual value of stocks and bonds they own.

But professor Warther found that "fund flows have no discernable relation to closed-end fund discounts, which are another often cited measure of investor sentiment."

Bottom line: ignore Wall Street analysts who look at flows of funds and make up your own mind about the individual funds and stocks you own.

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