Because equity fund investors have (mostly) held out in this year’s market slump

Market conditions were unusually tough in 2022. Broad market indices fell about 17.5% year-to-date through August 31, 2022, and tech-oriented growth stocks that previously led the market fell by 30. , 0% or more.

But at the same time, fund investors were effectively net buyers of US equity funds. This constant response may not last forever, but it is an encouraging sign. The merits of patience and long-term investment seem to be winning, at least for the moment.

Why fund investors didn’t panic in 2022

Equity fund investors have had a lot of cause for concern so far this year. After a strong rebound in 2020 and 2021, the markets went into panic mode. Market stocks have suddenly worsened, with negative headlines about the Russian invasion of Ukraine, stubbornly high inflation, and the risk that rising interest rates could trigger a recession in 2023.

Consequently, investor sentiment remains relatively negative. About 46.0% of investors who participated in the AAII Investor Sentiment Survey were bearish in the week ending September 14, 2022. This is down from a one-year bearish high of 59.4% in April 2022, but however well above the historical average of 30.5%.

The CBOE VIX Index, which measures market expectations for stock market volatility based on index options for the S&P 500, generally trended upward after a relatively quiet year in 2021. The benchmark leapt to lows in the 1930s earlier this year and it has recently been in the mid-1920s, compared with a long-run average of around 19.6.

However, fund investors seem relatively unmoved. Monthly inflows into U.S. equity funds (including mutual funds and exchange-traded funds) have been positive for five of the past eight months, with inflows estimated to total approximately $ 62.5 billion for the year to as of August 31, 2022.

Why the discrepancy between equity fund flows and market returns? First, fund investors represent a relatively small portion of total assets invested in publicly traded shares. Based on data from the Investment Company Institute, equity funds (including both mutual funds and ETFs) made up a total of 30% of the total market capitalization of US equities as of December 31, 2021. Investors of the funds are a large audiences, certainly, but they are not necessarily representative of the market in big writing.

Additionally, equity fund shareholders may be less inclined to panic selling because many of them are investing in pursuit of long-term goals, such as retirement. Mutual funds account for more than half of all assets in defined contribution plans and around 45% of assets in IRAs, based on ICI data. Many defined contribution plan participants automate their investments (by making an active choice or via default membership) by setting a percentage of the salary to contribute, choosing how to allocate resources to the funds available in the plan, and then investing in the same options throughout the ‘year. In many cases, this could result in the allocation of assets to a target date fund, which in turn would lead to more stable cash flows for the underlying funds.

Lessons from the past

Equity fund investors have not always been so resolute. In 2020, for example, estimated outflows from US equity funds were nearly $ 240 billion, or about 2.6% of assets at the end of the previous year. Outflows eased towards the end of the year, but many investors previously lost the market due to the rebound in equity market yields starting in late March and early April.

Equity fund flows also turned negative in the wake of the bear market driven by the financial crisis in 2008. Outflows over the five-year period from 2008 to 2012 amounted to approximately $ 214.5 billion. Investors who sold during that period lost some of the market’s double-digit returns starting in 2009, which continued mostly non-stop through 2018.

Overall, however, equity fund investors weren’t particularly inclined to sell at the wrong time. Most inflows and outflows tend to be relatively small as a percentage of assets. This, in turn, has helped US equity fund investors get a higher percentage of their fund returns.

In our annual Mind the Gap Investor Returns study, we examine the impact of cash flow timing on the actual results of fund investors. The difference, or gap, between investor returns and reported total returns represents the amount that investors gave up due to inadequate buying and selling.

For US equity funds, we found investor returns lagged total returns by 119 basis points, on average, for the 10 years ending December 31, 2021. This compares favorably to the 173-point gap base across all category groups. Over the same 10-year period, total returns on US equity funds averaged 15.9% annually and investors earned dollar-weighted returns of 14.7% on average.

A bar chart showing investor returns, total returns, and the difference between the two for US equity funds over the last 10-year period ending December 31, 2021.

Will patience pay off?

There are still many reasons why investors are shady. Inflation has failed to moderate as quickly as many investors previously hoped for. After making several federal funds rate hikes earlier this year, the Federal Reserve recently adopted a more aggressive tone, suggesting that further tightening may be needed to contain inflation. At the same time, analysts have revised down their estimates for quarterly earnings growth and recession fears loom for 2023.

Investors weren’t completely unflappable either. As I explained in my previous article, many bond fund investors bailed out in response to this year’s terrible returns on fixed income, and that could still happen on the equity side. Monthly net flows fell into negative territory in January, April and August of this year and that trend could accelerate if market turmoil continues.

A bar chart showing estimated monthly net flows for US equity funds for the first eight months of 2022.

So far, however, the generally balanced response from equity fund investors to this year’s market turmoil is an encouraging sign. Things can get tough in the short term, but investors who buy and hold usually reap rewards over time.

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