Tuesday, April 3, 2012

Fear

Investors continue to pour money into bond mutual funds.

According to Matthew Kelley at Morgan Stanley, nearly $38 billion moved into funds that invest in domestic, international and municipal bonds during the first quarter of 2012.  This pace of investment is +14% higher than the same period of 2011.

Meanwhile, despite a +25% rise in the S&P 500 in the last six months, money continues to flee equity mutual funds.

Year-to-date approximately $7.4 billion has left funds that invest in domestic and foreign equities, according to Mr. Kelley.  This pace is in line with the same rate of withdrawal for the same period in 2011.

I continue to be dumbstruck by this trend.  Interest rates are at 60-year lows and the risks in bond mutual funds are far higher than most investors perceive.

Stocks, meanwhile, are perceived to be too risky for ordinary investors, despite the fact that equities are perhaps the only asset class that offers savers a reasonably possibility of building a decent retirement portfolio.

One of the most popular bond mutual funds is run by Bill Gross at Pimco. After a period of withdrawals last year, investors have returned to Pimco's bond offering:
 
Bill Gross’s Pimco Total Return (PTTRX) Fund, the world’s biggest mutual fund, attracted $1.7 billion of investor deposits in the first quarter as performance rebounded. 

The fund last had deposits in the third quarter of 2011, when it brought in $2.3 billion, according to data compiled by Chicago-based Morningstar Inc. (MORN) Investors pulled about $3 billion from the fund in the three months ended Dec. 31, bringing withdrawals last year to $5 billion, Morningstar said. 

http://www.bloomberg.com/news/2012-04-02/pimco-s-total-return-fund-attracts-1-7-billion-in-first-quarter.html

Is this a good trend?

According to Pimco's website, the yield of the Total Return fund is 3.86% - pretty attractive in total's low interest rate environment.



The fund hold 52% of its assets in mortgage-backed securities, and another 10% in debt of emerging market governments. 

http://investments.pimco.com/ShareholderCommunications/External%20Documents/Total_Return_Monthly_Commentary_700.pdf

But here's a statistic that I bet most investors don't focus on.

The duration of the Total Return fund - that is, the measure of the price sensitivity of the fund to changes in interest rates - is 5.7 years.

What does this mean to their investors?

If interest rates rise 100 basis points from current levels, the price of the Total Return fund will decline by roughly -6%. 

And, if rates return to the levels of March 2011, investors will find losses of nearly -10%.

All this from a "safe" bond fund.

This is not to pick on the Total Return fund - Bill Gross is one the best bond managers of this era - but rather to point out that even Mr. Gross will be unable to stem the losses in his fund if interest rates start to move higher.

This is true for any bond mutual fund, by the way.  Interest rate risk is common to any fund, regardless of the skill of the manager.

And then there's this:

If you buy a bond directly - and not through a bond mutual fund - you can at least be assured that you will get your investment back at maturity, regardless of the future path of interest rates.

However, if you invest in a bond mutual fund today, and interest rates move higher for a sustained period of time, you face the very real possibility that you will suffer a permanent loss of capital.

So why are bond funds so popular?

Perhaps the best response comes from Amy Resnick, who follows Random Glenings via Twitter:

"Fear."