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Investors Remain Averse to Diversification

Investors just do not take a hint when it comes to using bond funds as a diversification vehicle, according to industry analysts.

With the stock market booming in the late 1990's, investors were reluctant to use bond funds and diversify their assets, analysts say. Equity markets were too lucrative, the logic went. Why invest in bond funds that yield far lower returns?

But, with Wall Street's nosedive beginning in April 2000, it began to look like the age-old idea of diversifying with bond funds was coming back into vogue. Bond fund inflows were high during this year's most brutal months on Wall Street. In both January and February, bond flows were $8.8 billion, according to Strategic Insight, of New York, a mutual fund research firm. Flows were $8 billion for March, the firm reported.

Then equity markets began their rally. And bond fund flows plummeted. Flows dropped some $7 billion to $1 billion in April, according to Strategic Insight. In addition, muni bonds had redemptions of $1.4 billion in April, according to Strategic Insight.

Part of the decline stems from the fact that net asset values for bond funds dropped 0.8 percent in April, said Avi Nachmany, director of research at Strategic Insight. Investors were also liquidating investments to pay taxes in April, he said. And many became concerned about inflation as long-term interest rates rose, he said.

But some analysts who, based on this year's early flow numbers, thought using bond funds to diversify might have been back in fashion, now think investors were only temporarily sheltering their assets to protect them from plummeting equity markets.

"It's primarily defensive switching, not so much opportunist buying," said Nachmany of the solid bond flow numbers in the first three months of the year.

Investors thought "that they were a little overexposed in the stock market" and that "bonds might protect them a little more on the downside," said Scott Berry, an analyst at Morningstar.

But, apparently, that was short-term thinking, demonstrated by investors' rush back into equity funds, Berry said.

"I think you've got an ethic at work here for long-term retirement planning that says equities are the way to go," said Burton Greenwald, president of B.J. Greenwald & Associates, of Philadelphia.

But he said bond funds are likely to become more popular as Baby Boomers inch closer to retirement and switch their focus from increasing assets to maintaining them. When people retire, it behooves them to shift their assets to less-risky investments such as bond funds, he said.

Short of that trend substantially increasing bond fund flows, it would take a long, sustained period of flat or declining equity markets to increase the popularity of bonds, said Greenwald.

"If the markets begin to waiver again, I think you'll see the fixed-income funds come back again," he said.