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Investors Shake Up Funds With Record Bond Love Affair

Retail investors in the U.S., burned by two market crashes in a decade, have shunned stocks for the longest stretch in more than 23 years, upsetting the balance of power in the $10.5 trillion mutual-fund industry.

Bond funds attracted more money than their equity counterparts in 30 straight months through June, according to the Investment Company Institute, a Washington-based trade group. Preliminary data show the trend continued in July, matching the streak posted by bonds from 1984 through 1987.

The shift is pressuring asset managers, especially equity- focused firms such as Janus Capital Group Inc. and Capital Group Cos., because bond funds charge about 20 percent less in fees. Among the big winners are bond specialist Pacific Investment Management Co. and Vanguard Group Inc., whose index stock funds have become popular alternatives to actively managed portfolios.

“Retail investors are still shocked by what has happened in the past two years,” James Kennedy, chief executive officer of fund manager T. Rowe Price Group Inc. in Baltimore, said in an interview last month after releasing second-quarter earnings that fell short of analysts’ estimates.

Bond funds attracted $559 billion industrywide in the 30 months through June, according to ICI. Investors pulled $209.4 billion from domestic equity funds and $24.4 billion from funds that buy non-U.S. stocks.

Stocks fell 26 percent including reinvested dividends during the period, as tracked by the Standard & Poor’s 500 Index. Bonds returned 16 percent, based on Bank of America Merrill Lynch index data.

The Case for Stocks

Fund companies are trying to lure investors back into equities. Franklin Resources Inc., in a marketing campaign started in January, says that history shows stocks usually do well following a decade in which they lost ground.

“But many investors are turning their backs on equities now -- after one of the worst decades the stock market has ever seen,” the company, manager of $603 billion including the Franklin and Templeton funds, says in a presentation on its website.

Investors aren’t biting. In the first half of 2010, 98 percent of the money that San Mateo, California-based Franklin attracted went into bond funds.

“We are going to keep talking about equities,” CEO Gregory Johnson said on a July 29 conference call with investors. Johnson said he was concerned investors were putting “too much” money into bonds, whose price falls when interest rates rise, without realizing the risks involved.

‘Hair-Trigger Mentality’

The speed and depth of the market’s decline has rattled investors in a way past selloffs didn’t and has conditioned them to retreat from stocks at the first hint of trouble, said Jim Jessee, president of the U.S. fund business for Boston-based MFS Investment Management.

In the week following May 6, when the Dow Jones Industrial Average briefly lost almost 1,000 points and then recovered, investors pulled $12.3 billion from stock mutual funds, ICI data show. In April, equity funds had deposits of $13.2 billion.

“People have developed a hair-trigger mentality,” said Jessee in a telephone interview. “Their feeling is: ‘I am not going to be too slow the next time.’ ”

The S&P 500 has fallen 12 percent from its high for the year on April 23 amid signs the economic recovery is slowing. Investor pessimism deepened after the Federal Reserve said Aug. 10 that growth probably will be “more modest.” The central bank said it will maintain its holdings of securities to stop money from draining out of the financial system, its first move to bolster the economy in more than a year.

Little Good News

“It is hard to pick up the newspaper and see anyone optimistic,” said Francis Kinniry, who studies investor behavior for Vanguard, which is based in Valley Forge, Pennsylvania. “The problem is there is not a lot of good news on the recovery front and that translates in people’s mind into poor capital markets.”

Only one of the 10 best-selling mutual funds in 2010, the $117 billion Vanguard Total Stock Market Index Fund, invests exclusively in stocks, data from research firm Morningstar Inc. show. Its success shows that when investors put money into stocks, they prefer index-based funds over those that are actively managed.

Vanguard, a pioneer in indexed investments, attracted $58 billion in deposits to its stock funds over the 30-month period, the most of any company, according to Chicago-based Morningstar. Over that stretch, U.S. investors put $111 billion into stock index funds even as they withdrew $271 billion from equity funds whose managers pick securities.

Fees Squeezed

Vanguard, which has almost $1.3 trillion in mutual funds, manages an additional $112 billion in exchange-traded funds, which typically mimic indexes while trading throughout the day like stocks. The firm is owned by investors through their mutual-fund holdings.

Investors are using bond funds as a haven from the turmoil in equity markets, squeezing firms previously accustomed to the fatter fees charged by stock funds.

On a dollar-weighted basis, the average stock fund collects 76 cents in fees for every $100 invested, compared with 61 cents for bond funds, according to Denver-based Lipper.

The impact can be seen in return on equity, a measure of profitability, reported by publicly traded asset managers.

At T. Rowe Price, ROE fell to 22 percent in the second quarter from 26 percent in the fourth quarter of 2007, the last before the bond-dominance streak began. Stock and blended portfolios accounted for 72 percent of the company’s $391 billion in assets, down from 80 percent.

‘On the Sidelines’

Franklin’s ROE declined to 19.5 percent from 26 percent in the same period, as equity funds dropped to 41 percent of assets from 59 percent. ROE at Legg Mason dropped to 4 percent in the second quarter from 10 percent at the end of 2007, while stock funds fell to 24 percent of its $645 billion of assets from 32 percent.

“A big part of the problem is that people are still sitting on the sidelines in this market environment,” Mary Athridge, a Legg Mason spokeswoman, said in an e-mail.

The company posted net deposits into stock funds for the first time in more than four years in the second quarter.

Janus, with 93 percent of its $147 billion in assets in stocks, “has probably been hurt the most,” said Jonathan Casteleyn, a New York-based analyst for Susquehanna Financial Group LLLP.

The Denver-based company earned $61.5 million in the first half of this year, down 27 percent from same period in 2007. Equity assets fell 28 percent during the 30 months through June as investors pulled $3.9 billion from its stock funds and the decline in stock prices reduced the value of existing holdings.

Boon for Pimco

Janus’s return on equity climbed to 12.1 percent in the June quarter from 5.8 percent in the final three months of 2007, when earnings were depressed by a writedown of the value of a printing unit. James Aber, a spokesman for the firm, declined to comment.

The S&P index of 15 asset managers and custody banks lost 44 percent including dividends from the start of 2008 through June 30, 2010. That compares with the decline of 24 percent by the S&P 500.

The move by retail investors into bond funds plays to the strength of Pacific Investment Management, which started in 1971 as a fixed-income manager and whose $1.1 trillion in assets includes just $600 million in stock funds.

While Pimco’s parent, Allianz SE, doesn’t report financial results for the Newport Beach, California-based firm, the German insurer said on Aug. 6 that operating income at all its asset- management units more than doubled to 516 million euros ($656 million) in the three months ended June 30 from a year earlier.

Mark Porterfield, a Pimco spokesman, declined to comment on the firm’s profitability.

By other measures, Pimco is thriving. It attracted $40.2 billion in the first half of 2010, more than any other fund company, according to Morningstar. Pimco Total Return Fund, run by Bill Gross, had deposits of $20.9 billion in the period, the most for an individual fund.

American, Fidelity

The $239 billion fund, the world’s biggest, returned 5.8 percent in the first half, compared with a loss of 6.4 percent by the average stock fund.

The rise of the $822 billion ETF business, along with the shift to bonds, has hurt firms with a reputation for active management, including Capital Group and Fidelity Investments, which are both closely held.

American Funds, part of Los Angeles-based Capital Group, had $48.8 billion in withdrawals from stock funds in the 30 months ended in June, more than any other fund firm, Morningstar data show. American Funds has 72 percent of its $950 billion of assets in stocks and 19 percent in bonds, Chuck Freadhoff, a spokesman for the firm, said in an e-mail.

Fidelity experienced $48.1 billion in withdrawals from its stock funds in the two and a half year period, the second-most after American Funds, Morningstar data show.

1987 Streak

Fidelity said its withdrawals in the period were $32.8 billion, according to an e-mailed statement from Vincent Loporchio, a spokesman for the Boston-based firm.

Both American Funds and Fidelity have largely ignored ETFs.

From September 1984 through March 1987, a 31-month stretch, bond funds took in more money than stock funds, ICI data show, even as the S&P 500 Index rose 75 percent. Many U.S. investors were not yet comfortable owning stocks in the mid-1980s, said Geoff Bobroff, a mutual-fund consultant in East Greenwich, Rhode Island.

“In contrast to today, bonds also offered pretty good returns back then,” he said in a telephone interview.

The 10-year U.S. Treasury note had an average yield of 9.3 percent in that period, according to data compiled by Bloomberg. The 10-year note yields less than 3 percent now.

Institutions More Bullish

Fund investors’ latest aversion to stocks contrasts with buying by institutions such as pension plans and endowments, whose equity holdings rose to 68 percent of assets in July, the highest level in 15 months, a Citigroup Inc. survey showed.

If institutions ignite a sustained run-up in stocks, individual investors will eventually jump back in, said Jack Ablin, who helps manage $55 billion as chief investment officer at Chicago-based Harris Private Bank.

“What will happen is that the market will rally first, and retail investors will chase it later,” he said in a telephone interview.

More than 80 percent of investors polled in July by Fidelity said they wanted to see at least six months of market stability before making further investments.

Lasting Scar

“Someone who is waiting for stability is likely to miss out on the upside,” John Sweeney, an executive vice president at Fidelity, said in a telephone interview.

Sweeney said that in speaking to clients the firm stresses the value of diversification and the importance of owning stocks, especially for younger investors who may be 30 or 40 years from retirement. Fidelity has $1.25 trillion in mutual- fund assets.

Vanguard’s Kinniry said that the reaction to the 2008 market decline “is different from what we have seen in other bear markets.” Investors have been slower to return to stocks, he said, despite a roughly 60 percent climb for the S&P 500 Index since prices reached a 12-year low in March 2009.

The swiftness of the 2008 crash may explain some of the caution, said Kinniry.

From Sept. 2 to Nov. 20, 2008, the S&P 500 Index fell 41 percent, according to data compiled by Bloomberg. Investors were further frightened by the decline in home prices that was already underway, Kinniry said in a telephone interview. U.S. home prices dropped by almost one-third from July 2006 to April 2009, according to the S&P/Case-Shiller index.

Jessee of MFS said it may take a major market rally to get investors back into stocks.

“Unfortunately, my gut tells me the market will need to go up 30 to 50 percent,” he said.

To contact the reporter on this story: Charles Stein in Boston at cstein4@bloomberg.net

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