Think Twice Before Dumping Your Bond Fund
Thursday, July 11, 2013
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 48.9%, up 6.9 points
  Neutral: 32.8%, down 1.4 points
  Bearish: 18.3%, down 5.5 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »

Investors have been yanking their dollars out of bond mutual funds. An estimated $66.6 billion has been pulled over the past five weeks, according to the Investment Company Institute (ICI). This is more than eight times the amount pulled from domestic equity funds over the same period.

The rotation out of bond funds has caused two major fund companies to experience net outflows from their entire family of funds. In a conversation with Investment News reporter Jason Kephart, a Vanguard spokeswoman noted that her firm incurred net outflows of $100 million last month. Though much of the cumulative $9.7 billion pulled from Vanguard bond funds last month was reinvested back into stock and money market funds, clearly not all of it was.

Vanguard was certainly not the only victim, either. Pacific Investment Management Co. (aka PIMCO) incurred $14.5 billion in outflows. This made June the first month with net outflows for the firm since December 2011.

Clearly, investors are noticing the rise in bonds and reacting. Yields on the benchmark 10-year Treasury note have risen by more than a full percentage point since May 2, 2013. (Thanks to Federal Reserve Chairman Ben Bernanke’s comments yesterday afternoon, the magnitude of the rise has been reduced to 0.94 percentage points). As yields rise, bond prices fall, so it might seem like the recent outflows from bond funds are the right move. But, data from both the ICI and DALBAR Inc. show that market timing decisions by mutual fund investors lead to poor performance results. In particular, DALBAR calculates that the average equity mutual fund investor realized less than half of the gains generated by the S&P 500 during the 20-year period ended in 2011. A major contributing factor was the short time period that funds were held.

I know it is hard to hold onto a fund when the prices of the underlying are assets falling. But before you pull money out of a bond fund, look at your 2003 and 2009 statements. Did you put money back into equity funds during the first half of either year? If the answer is no, you should question your ability to know when the ideal time to get back into bond funds will be.

My personal strategy is to simply rebalance if my bond fund holding falls in value too much. I hold the Vanguard Intermediate-Term Investment-Grade fund (VFICX) in my 403(b) plan and have kept contributing to it. I chose this fund because it provides a good middle ground between yield, interest rate risk and credit risk. Nobody knows how much bond yields will actually rise in the future, much less when the next upward move will occur, so I’m content taking a middle-of-the-road approach.

Hedge Fund Ads Forthcoming

Yesterday, the Securities and Exchange Commission (SEC) lifted what was nearly an 80-year-old ban on general solicitation and advertising for certain private securities offerings. The change in regulation means hedge funds will now be allowed to advertise to and solicit the broad audience of investors. The SEC’s hand was forced by the Jumpstart Our Business Startups Act (aka, the JOBS Act), which directed the commission to lift the ban.

Under the new rule, hedge funds can advertise broadly, provided they take reasonable steps to ensure they only accept investment dollars from accredited investor. An accredited investor has a net worth in excess of $1 million (excluding the value of their primary residence) or annual income in excess of $200,000 ($300,000 joint income for married couples) and a reasonable expectation of similar earnings in the current year. These wealth requirements imply that many people who see the hedge fund ads won’t be eligible to invest the funds.

For those of you who do qualify as accredited investors, there remains the question of whether you actually should become a hedge fund investor. The name hedge fund is a misnomer since many resemble total return or alternative strategy funds rather than ones actually designed to hedge against risks. Fees are high, especially for those who follow the traditional 2 and 20 rule: a 2% annual fee on assets managed and a 20% levy on profits. Making matters worse is the performance. Citing data from the HFRX Global Hedge Fund Index, Barry Ritholtz wrote on his The Big Picture blog: “Over the past five years, the hedge fund index lost 13.6%, while the [stock] indices added 8.6%. That’s as of the end of 2012; it has only gotten worse in 2013.”

Of course, the ads will play up the positive traits of hedge funds. The ads will likely cite alternative strategies and expert management. What they won’t mention is that once a fund figures out a good strategy, others will quickly try to replicate it. This copycat syndrome contributed to the demise of Long-Term Capital Management in the late 1990s and will hurt hedge fund performance going forward.

More on

AAII Sentiment Survey

Pessimism among individual investors fell to its lowest level since January 2012, according to the latest AAII Sentiment Survey. Optimism, meanwhile, surged higher for the second consecutive week.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 6.9 percentage points to 48.9%. This is the highest level of optimism registered by our survey since May 23, 2013. The historical average is 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, declined 1.4 percentage points to 32.8%. This is the seventh consecutive week and the 13th in the past 16 weeks that neutral sentiment is above its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 5.5 percentage points to 18.3%. This is the lowest level of pessimism since January 12, 2012. The historical average is 30.5%.

During the past two weeks, bullish sentiment has risen by a cumulative 18.6 percentage points and bearish sentiment has fallen by a cumulative 16.9 percentage points. At current levels, optimism is at the high end of its typical range (+1 standard deviation is a reading at or above 49.3%). Bearish sentiment is just shy of being at extraordinarily low levels (-2 standard deviations is a reading at or below 17.8%).

Since March, there have been sizeable swings in the sentiment pendulum, both to the bullish and the bearish sides. The recent optimistic stance comes as stocks have rebounded off of their June lows and are approaching record highs. Some AAII members are encouraged by signs of continued economic growth and the length of the current rally. Others, however, are concerned about prevailing valuations, the slow pace of economic growth, interest rate uncertainty and a lack of progress on key issues by Washington politicians.

This week’s special question asked AAII members how much impact foreign events such as the Brazilian protests, the Egyptian political crisis and the Chinese liquidity crunch are having on their six-month outlook for stocks. More than half of the respondents (56%) said the events were having no or very little impact on their outlook. One respondent observed, “The world is a mess, but then again, it’s always a mess.” Approximately 19% said the events have some impact, while just 9% said the events are significantly impacting their outlook. A small number of respondents (6%) said the foreign events will increase volatility within the U.S. markets.

» Take the sentiment survey