Fight on, or fall back?

Mutual Funds Quarterly: Third Quarter - 2001

Fight or flight? For millions of investors, worried about the prospect of grim returns for the rest of 2001, the question is stark and daunting. Yet, the answer has come through loud and clear: Small investors - in many respects the backbone of the US financial system - have chosen to fight.

With few exceptions, they are staying put in mutual funds and individual stocks, despite sagging returns for the quarter and year to date - not to mention the uncertainty cast upon the market by last month's terrorist attacks and Sunday's military strikes by the US and Britain. Stock market defectors after Sept. 11 came largely from institutions, such as large pension funds using special computer-sell programs.

"Just based on anecdotal evidence, we are not finding any unusual level of redemptions by individuals from mutual funds," says Chris Wloszczyna, a spokesman for the Investment Company Institute (ICI), the national association of the fund industry in Washington.

Although some investors were pulling out of stock funds well before the World Trade Center disaster - based on weaknesses in the economy - flows into these funds remain in positive territory for the year, with even more money going into bond and money-market funds. During the third quarter, outflows from stock funds accelerated. But flows increased into both money-market funds and bond funds (see chart, page 17).

Overall, fund ownership keeps rising. According to the ICI, 54.8 million US households - 52 percent of all US households - own mutual funds, a 3 percent rise over last year. And a new poll of some 1,000 Americans indicated that half had purchased, or plan to purchase, "some type of financial product or security" specifically to help the US economy, according to InsightExpress, an online market-research firm.

Those already in the money-market and bond categories likely profited during the past quarter. But returns on equity funds, especially after the destruction of the twin towers, can only be called dismal.

Virtually every stock mutual-fund sector lost ground, with two exceptions: gold funds and bear funds. Gold gained an average of 2.3 percent in the third quarter, but has taken a hit in recent trading sessions. Bear funds did even better, producing double-digit returns.

Bear funds tend to profit by owning options on equities rather than actual stocks, in anticipation that stocks will lose value. Both gold and bear funds are volatile. But bear funds are also expensive, often requiring $10,000 to $25,000 to open an account.

For holders of fixed-income funds, there was particularly good news during the quarter. The bond market posted solid gains, especially for intermediate-range bond products of three years or more.

Public attention, not surprisingly, has been riveted on the terrible destruction in New York and the first round of US reprisals. Many US financial firms were both financially and personally affected by the tragedy. But longtime financial experts insist that to gain a clear perspective, investors must look far beyond the immediate impact of the terrorist incident and even armed conflict.

"What happened at the World Trade Center was a terrible personal tragedy," says John Markese, president of the American Association of Individual Investors, in Chicago. "But the impact on financial markets is not as severe. Events like this, as terrible as they are, tend not to have lasting impact."

Unless people have unusual circumstances or changes in their lives, we tell them to "do nothing to alter their own personal investment plans," Dr. Markese adds.

Longtime market watcher Thomas O'Hara, chairman of the National Association of Investors Corp. (NAIC), in Madison Heights, Mich., says small investors should remain in the stock market. Mr. O'Hara, who has lived through the Great Depression, World War II, the stock market doldrums of the 1960s and '70s, Vietnam, the market crash of 1987, and the Gulf War, believes today's down market is "much like the others that investors have also been through."

In every case, he says, whether it was depression or war, financial markets have always rebounded, and US companies have gone forward, creating new products, providing fundamental services - and returning profits to shareholders.

"If you pick good-quality corporations with a record of outstanding management, you will be rewarded over time," he says. Based on experience, O'Hara believes that even the badly battered high-technology sector will rebound sometime in the next year or so. Technology represents "the future," he says (story, above).

Investment houses tell a somewhat similar tale, presumably based on a careful reading of economic fundamentals, but perhaps also, in part, out of self-interest.

Barring more domestic terrorism, "the stock market will be moderately higher by the end of 2001," says Alfred Goldman, chief market strategist for investment house A.G. Edwards & Sons in St. Louis. The Dow Jones Industrial Average, he says, will close perhaps just below the 10000-point level before the year is out.

Domestic growth should be up in the first quarter of 2002, Mr. Goldman adds. That should help propel equities into positive territory for next year.

"Investors have some faith that the economy will eventually turn around, based on continuing interest-rate cuts by the Federal Reserve, and the emerging fiscal stimulus package out of Washington," says Arnold Kaufman, editor of The Outlook, a financial review published by Standard & Poor's Corp.

Standard & Poor's economists, according to Mr. Kaufman, now believe that the US entered into recession around April 2001, well before last month's attacks. Since the average recession lasts about 11 months, says Kaufman, that could mean that the US is halfway through the downturn, and perhaps on its way back up.

The Fed rate cuts and economic stimulus programs passed by Congress should be working their way back through the economy by next spring, says Larry Wachtel, a vice president with investment house Prudential Securities Inc. For small investors, he says, that suggests that this may be a good time "to begin a buying program, if you have not already done so."

For long-term stock investors seeking relative financial safety, the evidence seems indisputable that losses tend to be lessened in down markets if you own stock mutual funds, rather than individual securities.

According to preliminary data from information firm Morningstar Inc. in Chicago, almost half of the 7,096 stocks it tracks lost at least 20 percent or more of their value in the third quarter. By contrast, of the 8,972 stock funds tracked by Morningstar, only 28 percent lost 20 percent or more of their value. Driving home the advantages of funds: 15 percent of the individual stocks tracked lost 50 percent or more of their value in the third quarter, versus only 0.5 percent of stock funds.

Among sectors showing promise: defense, consumer goods, and healthcare.

"The stock market across the board is cheap at this time," says Peter Donovan, president and CEO of Wright Investors' Service in Milford, Conn. He recommends that mutual-fund investors buy large or mid-cap blend funds.

What about investors just unable to deal with stocks' volatility? Financial specialists suggest that besides conservative bond and money-market funds, one can invest in US government securities, including I bonds, as well as bank certificates of deposit.

"Over time, however, returns from stocks will beat all other alternatives," says O'Hara of the NAIC.