Expectations on rise for investment rotation
NEW YORK — After years of sticking with plain-vanilla bond funds, investors are starting to turn their backs on them and opt for stocks. The move isn't big enough to be the “great rotation” from bonds to stocks that many experts predicted — it's more of a good rotation — but fund managers say more is on the way.
Investors plugged $198 billion into stock mutual funds through the first 11 months of the year. That's the most since the dot-com stock bubble in 2000, according to Morningstar. Bond mutual funds are also taking in money, but the dollars are increasingly going only to niche corners of the market. Investors pulled $73 billion out of the largest category of bond mutual funds, intermediate-term bond funds, over that time. It marks a stark shift in behavior. Since the 2008 financial crisis, investors have largely sought the safety of bonds and shunned stocks.
Heading into this year, many strategists expected investors to dump their bonds and move into stocks en masse. Bonds had served investors well for three decades, but interest rates had fallen sharply. Stocks, meanwhile, have the potential to offer bigger returns. Early this year, there was no rotation, as investors were comfortable adding money to both stock and bond mutual funds.
“Then a switch went off in May,” says Michael Rawson, a fund analyst at Morningstar. That's when worries about rising interest rates began to spike, which hurt bond prices. Investors have since increasingly shown their preference for stocks over traditional types of bond funds. Consider:
• In June alone, investors pulled $16 billion out of municipal bond mutual funds, according to Morningstar. Through November, investors have yanked a net total of $49 billion this year.
• Net investment in stock mutual funds and exchange-traded funds this year will likely top that of the four prior years combined, according to Strategic Insight, which tracks the mutual fund industry.
• In a sign of how the tide has turned, Vanguard last week closed one of its stock mutual funds to most new accounts and re-opened two of its bond funds. Funds typically close to new investors when they're attracting lots of money and want to keep from getting too big and unwieldy. They reopen when they want to attract more dollars.
A major driver for the shift is fear that rising interest rates will hurt bond funds. When interest rates rise, prices for existing bonds fall because their yields suddenly look less attractive. During the summer, such worries flared as the yield on the 10-year Treasury note nearly doubled from 1.6 percent at the start of May to roughly 3 percent in September.
Stocks, meanwhile, have climbed around the world amid rising corporate earnings, stimulus from the Federal Reserve and hope that economies from Europe to Japan are improving. The Standard & Poor's 500 index set a record high earlier this week.
To be sure, most investors will always have some interest in bonds. They tend to be less volatile than stocks, and the need for income investments will rise as more baby boomers retire. Pension funds and other institutional investors also need the steadiness that bonds provide.
“You need to have that anchor to lower volatility,” says Avi Nachmany, director of research at Strategic Insight.
Investors used to flip between investments quickly and opportunistically, Nachmany says. But now, they increasingly stick to a plan and keep a certain percentage of their portfolios in stocks and a certain percentage in bonds. Target-date retirement mutual funds have grown in popularity, for example, and they always keep a portion of their investments in bonds.
This means money will continue to flow into bond funds, particularly those that can better weather rising interest rates. These include floating-rate funds, whose yields ratchet higher with broad market rates, and possibly high-yield bond funds. Investors are also turning to mutual funds that use hedge-fund techniques to try to provide steadier returns, Nachmany says. Investors who have made the move from bonds to stocks have set themselves up well, if Wall Street strategists are to be believed. Most investment banks are forecasting continued gains for stocks in 2014, though more modest than this year's 24.5 percent surge.
“Investors have begun to see the potential for stocks after 10 to 12 years of getting not much return, versus high-quality bonds,” says John Manley, chief equity strategist at Wells Fargo Funds Management. “I think it's just the beginning” of the rotation into stocks from bonds.