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If Investors Are Dumping Stocks, Why Are ETFs So Hot?

It's increasingly tricky to understand how investors really feel about the stock market. On the one hand, they are withdrawing assets from equity mutual funds, according to the weekly fund flows data reported by Lipper and other organizations that use this information as a barometer of investor sentiment. That trend has given rise to reports that investors are fleeing stocks and foolishly piling into bond funds. On the other hand, investors continue to plow money into equity-linked exchange-traded funds, or ETFs.

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That sounds counterintuitive, since in theory a large-cap stock fund is going to give an investor roughly the same kind of market exposure as an ETF based on the S&P 500 index or other similar broad market barometer. And yet, the pattern repeated itself in the most recent five-day period reported by Lipper, as investors yanked some $4.1 billion from the coffers of equity mutual funds while investing a net $6.3 billion into equity ETFs. That's the 20th consecutive week in which U.S. equity mutual funds have experienced net withdrawals, a trend that has remained in place regardless of whether major market indexes happen to be gaining ground or falling.

In contrast, the flows into or out of ETFs appear to be more volatile; while during many of those five-day periods investors have continued putting money into ETFs, it hasn't been as consistent a trend. In mid-September, for instance, ETFs lost assets.

Have investors developed some kind of multiple personality disorder? Or is there a logical explanation for this kind of data?

No one, to my knowledge, has tried to track the behavior of specific institutions or individuals who are making that move out of mutual funds and into equity ETFs instead. Therefore, we don't have any firsthand insights into why they might be making this kind of decision. Clearly, they can't all be dumping their stock mutual funds in favor of bonds or commodities.

This kind of pattern may reflect a lack of conviction on the part of investors. "Mutual fund investors typically need to stand by their decisions for at least 30 days, otherwise they may get hit with an early redemption charge," says Jeff Tjornehoj, head of Lipper Americas Research, who also has been monitoring and pondering this trend. The less convinced investors are that the stock market is likely to generate gains, on average, over the coming months, the less willing they will be to entrust their assets to a mutual fund manager.

To some extent, that attitude may have been fostered during last year's periods of extreme volatility, during which it became particularly difficult for any mutual fund manager to outperform the broad market.

The harder it is to generate alpha — returns that can't be explained by what the market is doing but that boil down to a manager's skill at identifying companies that will outperform the market — the more difficult it is for an active stock fund manager to add value. When macro concerns dominate the market — the election uncertainty, the European crisis, China's slowing growth, the looming "fiscal cliff" — it gets harder for strong companies to stand out in the market and for managers to see the value created by those companies reflected in higher stock prices.

ETFs, in contrast, give investors the same kind of liquidity that they get by owning individual stocks — they can be sold at any time of the trading day — while providing the same kind of diversification that a mutual fund offers. And in most instances, they do it very, very cheaply. For nervous investors who want to be sure they can get back into cash rapidly and aren't convinced that their mutual fund managers can outperform, the lower fees may be enough incentive to switch from one kind of investment vehicle to another.

Tjornehoj points out that the overall selling pressure on mutual funds masks the fact that "good" equity funds — those that have a solid long-term track record and that continue to do well on a risk-adjusted basis — are still pulling in cash. But net redemptions of lackluster or laggard funds have been overwhelming those inflows, a trend that has taken shape over the last few years. (Not all of those outflows are going into ETFs, Tjornehoj adds; a typical nervous mutual fund investor is just as likely to ratchet down his market risk and shift assets from stock funds to bond mutual funds.)

This trend raises a lot of questions about the way we approach investing, and about the way we gauge investor sentiment. Clearly, the ETF industry is booming; assets under management have grown at an annual rate of 30.2 percent over the last decade, according to London-based research group ETFGI. Those assets totaled $1.9 trillion as of the end of the year.

True, that's a drop in the bucket compared with the $23.8 trillion that the Investment Company Institute calculated was invested in mutual funds worldwide at the end of 2011. It's clear, though, that the growth in number and nature of ETFs make them not just a new kind of investment product, but more of a direct competitor to mutual funds.

ETFs can cope with volatile flows more easily than mutual funds that require hiring costly expertise in the form of analysts or managers. That's part of the reason ETF providers can offer the funds so inexpensively — and part of the reason we can expect a growing number of investors to use them as their investment vehicles of choice.

That in turn puts pressure on mutual fund companies, particularly those (unlike Vanguard, for instance) that have put their resources into actively managed mutual funds but that haven't been able to develop a particular niche (say, technology investing, or emerging markets) or a track record of outperformance. Today, it is the poorly performing fund that is losing market share to ETFs, as Tjornehoj points out; tomorrow, it may be those that aren't generating enough alpha on a consistent enough basis — a tougher standard.

As for those of us trying to understand what is going on in the financial markets, mutual fund flows appear increasingly irrelevant. We'll need to start spending more time looking at flows into or out of ETFs that are tied to broad market indexes instead, and couple that with a more granular look at mutual fund flows.

Global financial markets are complex; perhaps we shouldn't be surprised that a once-trusted "plain vanilla" indicator like mutual fund flows is no longer as reliable a signal as it once was.

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