Mutual Funds Are Riding Out the Storm

Here's some good news: So far, fund investors aren't panicking. If they keep hanging tough, it will be easier for the market to recover

By David Shook and Amey Stone

What have mutual-fund managers had in common with the Maytag repairman these past few days? Answer: They haven't had all that much to do. Granted, as the stock market tumbled 7% on Sept. 17, mutual-fund companies fielded thousands of calls from investors worried about the state of the markets when they reopened after being closed for four days. Yet despite heavy losses in stocks and very high call volume, fund investors didn't do that much selling, fund companies say. The same held true on Sept. 18, when the Dow Jones industrial average closed down just 17 points, to 8903.

At Strong Funds, call volume was 35% to 40% higher than a normal Monday on Sept. 17, says spokeswoman Jody Lowe. But she says redemptions were the same as an average Monday. She notes that the company's brokerage arm saw much more selling than usual -- but not among fund investors. Vanguard, Putnam Investments, and Dreyfus Funds also report no spike in redemptions, though Dreyfus and many other fund companies did see a slightly higher-than-average shift from equity to money-market funds. "By and large, most people just stayed the course and didn't make any moves," says Vanguard spokesman John Woerth.

Of course, mutual-fund investors aren't doing a lot of buying yet, either. Still, it's amazing that they held steady after the most devastating terrorist attack in the nation's history. On Sept. 17, Charles Schwab reported about $300 million in net fund redemptions (the total amount of money withdrawn from funds minus the amount added) -- far from a historic day in terms of outflows, says spokesman Morrison Shafroth. "There was no sign of panic among clients, evidenced in the fact that a very average net redemption day was recorded," he says.

"ENCOURAGING."

  This is a healthy sign going forward. With fund investors showing a willingness to stay put, it could be easier for the market to recover from the losses seen Sept. 17. After all, stock mutual funds represent 20% to 22% of the total market, according to mutual-fund trade group Investment Company Institute.

"It appears that mutual-fund redemptions are not a negative contributor to this particular market, and that is encouraging," says Bob Adler, president of AMG Data Services, which tracks fund flows. If index funds, which don't keep any cash reserves, were facing massive withdrawals and forced to sell holdings to meet redemptions, that would likely have shown up in overall market results on Sept. 18, Adler says.

Portfolio managers also took heart that the rate of shareholder redemptions within equity funds were not spiking, since it means they won't have to sell holdings to meet shareholders calls for cash. At ING Pilgrim, the number of investors pulling their money from growth portfolios edged up, says senior manager Jeff Bernstein. But "It was nothing that would have caused us to make any adjustments," he says.

DIFFERENT DYNAMICS.

  Mutual-fund investors tend to be a pretty steady bunch, despite perpetual worries that they might engage in mass selling, says Russ Kinnel, director of fund research at Morningstar. "Generally speaking, during periods of economic trauma, mutual-fund investors tend to freeze," adds Todd Hiller, director of client relationships for Strategic Insight, a fund-tracking company.

In fact, shocks to the stock market in recent history haven't caused a flood of redemptions among mutual funds, Strategic Insight has found. Even after the Persian Gulf War in 1991 and the market crash of October, 1987, redemptions stayed within a narrow band and didn't reach alarmingly high levels. However, AMG's Adler notes, market dynamics are very different now than they were 10 years ago, and past events don't really compare to the trauma inflicted on U.S. investors by the Sept. 11 terrorist attack.

No one can rule out the possibility that another attack on the U.S. or a retaliatory strike could spark a selling frenzy. But for anyone worried that panic among fund investors could send the market down further, another safety valve is in place: Cash positions at most fund companies are built up enough this year to sustain a sudden shock to the system. In July, cash ratios at stock funds rose to 5.6%, or roughly $200 billion, up from 5% in July, 2000. "In terms of trying to meet redemption demand, that's a sizeable percentage," says Investment Company Institute spokesman Chris Wloszczyna.

UNUSED PROVISION.

  With enough cash on the sidelines, fund managers don't have to sell stock to meet their obligations if lots of panic-stricken investors decide to redeem their shares at once. Also helping reduce that risk was a Securities & Exchange Commission ruling following last week's disaster that allows fund managers to more easily borrow cash to meet shareholder redemption demand. So far, that provision hasn't been necessary, says Wloszczyna.

Janus says fund managers are holding cash positions of 5% to 10%, depending on each fund's charter. Equity index funds don't have cash reserves, while value funds have among the highest cash positions, and growth funds are rarely higher than 10%.

"It has been a tough market even without the events of last week, and therefore we've had more cash on hand," says Pilgrim's Bernstein. He says the company's growth funds have between 3% to 6% of assets in cash.

Liquidity ratios at most mutual funds -- a key measure of cash on hand -- is just as important as cash on the balance sheet at individual companies. With fund companies building up liquidity levels, they're putting themselves in the same boat as companies that have billions of extra dollars in cash parked on the balance sheet for a rainy day.

LURING INVESTORS BACK.

  For many companies, that rainy day is here. With almost every industry affected in some way by the terrorist attacks, extra cash can help them not only pull through the economic storm but also buy back stock. Cisco, Intel, and General Electric, for instance, all have been actively buying their shares in the wake of the disaster. And while all airlines are facing a crippling loss of business and higher security costs, Southwest Airlines and Delta Airlines are in better shape than their competitors because of healthier cash flows.

Now, the trick is to convince individuals to wade back into this market. With a few days of stable markets, many fund-industry observers think investors will be back buying funds again -- although they're likely to keep diversifying among stock, bond, and money-market funds. "Even before this, investors were learning a very hard lesson about the value of being diversified," says Morningstar's Kinnel, who believes stock funds haven't lost their appeal despite the market's recent slide. "I don't think this means people should avoid stocks," he says. "Most people will find it very hard to reach their goals without stocks or stock funds."

Meanwhile, fund managers are greatly relieved that the worst-case scenario hasn't materialized yet.

Shook and Stone cover financial markets for BW Online in New York

Edited by Beth Belton