The current investor stampede into mutual funds qualifies as one of the great asset manias of the past 30 years.
Unfortunately, all asset manias end in cataclysmic bear markets. The format is always the same. Greed overcomes prudence as increasing numbers of investors are tempted by the prospect of larger and quick capital gains. The risks associated with deteriorating market value are ignored.
Eventually, the fundamental forces that started the mania begin to reverse and long-term value reasserts itself Prices collapse as investors rush for the exit and demand dries up.
Money is pouring into mutual funds at an unprecedented rate. Close to 600 new funds have opened in the past year, and incredibly, there are now more mutual funds in existence than there are companies listed on the New York Stock Exchange.
Deposits Drain Off
Net sales of equity and bond mutual funds reached a staggering $87 billion in the first four months of 1993 following record sales of $197 billion in the whole of 1992.
By comparison, the level of savings and time deposits at commercial banks and thrifts dropped by $45 billion in the first four months of 1993 and by $118 billion during 1992. That represented the first annual decline in bank deposits in the postwar period.
The pressures on banks to get into the mutual fund business are immense. Deposit rates have appeared increasingly unattractive in a world of low short-term interest rates and rising equity and bond markets.
Currently, the move into mutual funds seems like a win-win situation for both investors and banks. Investors have received returns far in excess of the paltry 3% or less available on deposits.
The banks, for their part, are holding on to their customer base, are earning good fee income, and have found another way to diversify away from their traditional but slow-growing and highly regulated business of making loans.
Many investors who have switched from deposits into mutual funds probably do not fully understand the increased capital risks that they assumed.
There is a tendency to invest using a rearview mirror. People typically assume that good past performance will guarantee similar performance in the future.
The stock market has delivered average total returns of about 18% a year in the past 11 years. Annual returns have averaged 12% in the past three years despite a generally gloomy economic backdrop. It is perhaps only natural that investors expect such returns to be maintained or even exceeded in an environment of economic recovery.
A Pricey Market
Investors are in for a rude awakening, because stock market returns will not be maintained at double-digit rates. Worse, a major correction in equity prices is likely during the next 12 months.
Profit growth is slowing relative to expectations, and interest rates are likely to rise later this year. Meanwhile, the stock market is expensive by most valuation criteria, with prices trading at more than 20 times prospective 1994 earnings.
The increased participation of normally risk-averse investors in the stock market increases the chance that the next correction could be unusually severe.
A low tolerance for capital loss is likely to cause more panic selling than normal when market expectations change for the worse.
Returns from bond mutual funds may also disappoint investors. Currently, the unusually steep yield curve provides a powerful incentive to invest in bonds or bond mutual funds rather than in money market assets.
However, interest rates will face upward pressure when the economic recovery gradually strengthens, and bond prices will fall. In the case of a five-year bond, yields would need to rise by only 60 basis points for total 12-month returns to fall short of the 3% available from a bank deposit.
New entrants into the stock and bond markets will get a shock the first time their quarterly mutual fund reports show a large drop in asset values. At that point, 3% interest income with no capital risk may not seem like such a bad deal.
The rush into the mutual fund business poses risk for the banks as well as for investors. Many banks perhaps do not realize the cyclical nature of the mutual fund business.
Indeed, too few professionals in the investment community at large have ever experienced a full-fledged bear market in stocks or bonds.
Investors and money managers have become conditioned to believe that price declines represent buying opportunities rather than a cause for concern.
At a recent meeting of the Investment Company Institute, the trade organization of the mutual fund industry, one industry expert expressed concern that bank mutual fund sales volume was too heavily oriented toward fixed-income funds.
He feared that rising interest rates would reduce the value of bond funds and said that "a big challenge for banks is to move investors into equity funds before rates rise."
This is an example of the kind of misleading advice that could get banks into trouble. An adviser who believes that interest rates are going to rise should recommend money market funds, not equity funds. Increased interest rates pose at least as great a threat to the stock market as to the bond market.
There is a danger that many banks are entering the mutual fund business with a lack of seasoned investment personnel that fully comprehend the market risks inherent in mutual fund investing.
In the wake of a stock or bond market. decline, many investors may decide to return to the safety of a bank deposit. However, they are unlikely to stay with an institution that failed to warn them about financial market volatility and risks.