Mutual Funds: In Fashion

Despite rumors to the contrary, individual investors are participating in the current market rally. But instead of buying individual stocks, many are putting money into mutual funds--especially those that invest in foreign stocks.

During the first four months of the year, investors poured a net $192 billion into U.S. based funds, up from $170 billion a year earlier, according to Morningstar.

Part of the reason investors are going the fund route: worry about another market meltdown. Although mutual funds and exchange traded funds carry their own risks, many investors see them as a way to spread their risk and are therefore considered safer than individual stocks.

“Our perception is that the general public is still fairly cautious to bearish on the U.S. equity market despite the run-up we’ve had,” says David Nelson, director of market analysis at Legg Mason Capital Management. “We think people are still traumatized by the bear market of 2000 – 2002. There’s still a mood of caution despite the strong advances.”

Joe Moglia, chief executive officer of brokerage firm TD Ameritrade, said on CNBC recently that investors are also concerned about the current economy.

'Not Overly Bullish'

“The individual investor is definitely involved, but not overly bullish,” Moglia told CNBC. “They are a little bit worried about GDP, the housing market and energy prices. They are involved, but they aren’t widely involved as the market rally indicated.”

Investors are still looking for returns, however. Despite caution at home, many are looking for bigger gains abroad by investing in international funds. In February and March, for instance, $22.23 billion flowed into international mutual funds, while only $12.15 billion went to domestic funds.

“Since the lows in the market in 2002, there’s been a steadily declining pace of investment into domestic mutual funds and a steadily increasing pace into international funds in addition to the growth we’re seeing in exchange-traded funds, ” Liz Ann Sonders, chief investment strategist for Charles Schwab, told CNBC.

It's unclear whether investors will return to individual stocks in a big way anytime soon. But some analysts say it's not too late to jump in. Though most expect the major indexes to rise further this year, they say investors should be prepared for bumps along the way.

Better Diversified

Harvey Hirschhorn, portfolio strategist at Bank of America, says the individual investor should be better diversified than many investors were during the 1990s tech boom.

“You have to own the large cap, small cap, foreign and if you’re into fixed income investments you have to be look at high-yield bonds,” he told CNBC.

Among exchange-traded funds, which are mutual funds that trade like stocks, Paul Schatz, president of Heritage Capital, says he likes Rydex equal weight ETFs.

“In the short-term, I like materials, industrials, and energy,” Schatz told CNBC. “If we can expand it a little further, I’d go into some large-cap pharmaceuticals, and the insurance sector. This is the fourth quarter of the rally. It’s getting narrower, more risk is coming in, but it’s also going to see the biggest price appreciation. The people who make the most money are going to be the ones who manage their risk on the downside.” 

Still, for now, caution appears to be the watchword for many investors.

“People who are not in the market ask if it’s too late to get in,” said Rob Brown, chief investment officer at Genworth Financial Asset Management. “Those who are in ask if it’s time to get out or pull back. For some, it’s not that the market is up, but that they’ve recouped their losses and feel it’s now time to take some chips off the table.”

© 2009 CNBC.com