Going With The Flow Of The Funds

B of A's Thomas McManus on how mutual funds help him peer into the market's future

Every stock market guru has a pet indicator. Some focus on mortgage rates, the U.S. money supply, or even the price of a Big Mac. For Thomas McManus, chief investment strategist at Bank of America (BAC ), it is the cash flowing into and out of mutual funds. McManus pays careful attention to this info to get a fix on investor sentiment, potential investment bubbles, and overall market trends. Personal Finance Editor Lauren Young spoke to McManus to decode the fund flows.

What do you learn from fund flows?

Mutual fund flows help us identify those worrisome moments when investors fall head over heels for a particular sector. Just look at the tech bubble. In the five months from November, 1999, to March, 2000, $47 billion went into technology funds. By the end of March, tech-fund assets hit $163 billion. So one-third of the assets in these funds had been invested for six months or less. That indicates how the crowd can be really wrong at major inflection points.

Technology funds haven't seen any significant inflows for several years. Is tech a good place to be right now?

Overlooked sectors can be a good area for investment, but they need a catalyst. There's none in tech right now. As a strategist, I try to identify the intersection of expectations and reality.

Do you worry that there's a bubble in international stock funds?

International funds have attracted more than $70 billion in new cash this year. While total assets of international funds relative to all equity funds have gone from 12.5% in 2002 up to 23.5% this year, I'm not worried. There are plenty of good reasons to be looking overseas, particularly in Europe, where companies have gotten their acts together in terms of governance and management.

Even so, I keep my eyes on certain fund families, such as Dodge & Cox, which operates a $38.5 billion international fund. The company closes funds to new investors when investment ideas are limited, but the fund is still open.

Are cash flows to exchange-traded funds a better market indicator than mutual fund flows?

Because they are actively traded, ETF flows are often temporary and unlikely to signal any real shift in sentiment.

Are investors finally shifting away from small-cap funds to large-cap funds?

Investors are still in love with these smaller-cap funds, and many don't realize the party is over. We've seen weak employment and chain store sales reports. Smaller companies that depend on rapid economic growth are at risk.

Large-cap growth companies haven't garnered much interest yet from investors, even though they have some attractive characteristics. Big companies tend to have greater international exposure and more borrowing capacity. That gives them an edge over smaller companies.

Fund managers aren't holding a lot of cash right now. What does that tell you?

On average, the typical U.S. stock fund has a mere 3.6% cash position, vs. the long-term average of 5%. But the fund industry has changed in the past decade. Portfolio managers today are not expected to anticipate the ups and downs of the market by holding more cash or less cash, so cash positions aren't the best indicator of their sentiment. The sell-off earlier this year also gave managers an opportunity to put money to work. However, cash is meant to be a cushion when funds have redemptions, and fund managers now seem a little bit less prepared than usual for potential weakness.

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