Closing the Doors on Return Chasers: Mutual Fund Inflows Create Problems

Like a torrential downpour can overwhelm gutters, flood streets and generally create the kind of havoc only water can, too much money flowing into mutual funds can also leave a mark on both new investors and those of record.

Now that the markets seem to be hellbent on leading the recovery (although there is still a popular consensus that this is not the real thing without jobs and earnings that are built on growth rather than cost-cutting), you have to wonder what is going on? Why is being asked quite frequently these days and many of the answers point to too much money on the sidelines suddenly feeling better about the opportunities and the fear of missing the recovery.

Investors who may have sold their stakes in funds that had done well for them in the past and then hurt them dramatically over the last part of 2008 are eyeballing this return to glory, ignoring the recent past at little more suddenly that I would have anticipated they would. Rushing back into the market is not what mutual funds need right now.

The Upside is the Downside
When investors flee, the remaining shareholders pay the price of staying. There are transaction costs and taxes to be paid (if the fund is forced to sell winning stocks to pay for redemptions) that are left for the fund to pay, passing on those costs. But those shareholders might benefit in the long run if their fund has positioned itself for the recovery. In fact, many investors are finding that staying put has them very close to the even point of where they closed the 2007 investment year.

But the problem with this rush is that it too causes an increase in costs for transactions and creates the possibility that too much money chasing too few stocks begins to artificially inflate those shares and we are off to the bubble races again. Some funds are so narrowly focused that the securities they need are being overbought.

This leaves investor money on the sideline, the exact place that it was before but no longer is. So fund managers are beginning to, at least temporarily close some of the hottest funds with the best year-to-date or quarterly returns. While this doesn't have any effect on shareholders currently in the fund, the problem of a deluge of new investors does not go away; it simply goes somewhere else.

This is especially problematic in the case of bond funds. Chasing performance while eluding risk is what bond investors have always sought. That and a return of their investment. Unless you own individual bonds, and plan on holding them to maturity, you may be unwittingly facing the same problem that mutual fund bondholders might be facing. Credit markets are still tight, the dollar is still weak and the economy has not yet fully embraced the enthusiasm of the stock markets. This makes bonds risky and increases the chances of default (which you will see in the increased yields).

When Fools Rush In
Overexposure and increased investments push bond prices higher and make profitable yields harder to find. This in itself, creates risk that many conservative and asset protection minded investors may not be willing to (or knowingly) assume.

At the same time, an opposite problem is looming for fixed income investors. Bonds are poised for difficulties in the coming years as inflation begins to rear its ugly head and deficit spending, necessary to facilitate the recovery begins to whittle away the current returns. For these investors, what would seem like a win-win situation might turn out to be something entirely the opposite.

Balanced funds and lifecycle funds may also be facing similar dangers as they try to increase bond exposure over time but are finding the endeavor more expensive than they would like. With fewer desirable bonds to purchase, these managers may be left with taking on more risk than the stocks in their portfolio have.

This imbalance could lead to more problems in the near term as investors seek out underinvested corners of the marketplace. The return chaser will simply head (or better, herd) for whatever is available. And a new cycle begins. Despite whatever notion of moving to a lower risk portfolio might provide, long-term investing still points to stocks as a safer haven. Which stocks is open for debate and future market gyrations. Yet, as fixed income portfolio managers try and warn their shareholders that this recovery is unlike any other, those looking for the safest of havens might not find what they are looking for in bond funds.

Paul Petillo is the Managing Editor of BlueCollarDollar.com