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Funds Solicit New Best Friends

With the prolonged market downturn, getting retail investors to keep assets in funds is becoming increasingly difficult, while institutional investors with their more disciplined investment style are becoming fund companies' new best friends.

When the markets were soaring and nearly all fund companies could boast stellar returns, getting retail investors to put money into mutual funds was relatively easy. While institutional investors pumped money in as well, they were less romanticized by the upswing and did so to a much lesser degree. And the same is true in the other direction.

Investors took out $29.5 billion from equity funds in September, more than ever before--though that is not a sign of panic and shareholders are responding normally to the bear market, said John Rea, chief economist for the Investment Company Institute.

However, not everyone is responding in the same way. In the third quarter, while retail investors pulled more than $7 billion out, institutional investors were putting more than $4 billion back into mutual funds, according to Financial Research Corp.

So far this year, retail investors have put $66.5 billion into funds, down more than 57% from year-ago figures of $156.2 billion, according to FRC. Institutional shareholders have reacted less negatively. This year, they've added $18.4 billion, down only 23 %.

The Reaction Is Not Good

The reactionary nature of retail investors in general, which triggered the enormous net inflows of 1999 and 2000, is now causing much of the exodus, said FRC research analyst Chris Brown.

"The number one thing that jumps to mind is that, in general, retail investors have a tendency to buy when the market is high and sell when it's low," said Brown. "Institutional investors have a lot more discipline, and buy when the market is low. I think it's a classic case of retail investors doing the wrong thing at the wrong time."

Linked to the notion that retail investors are more likely to chase performance is the idea that institutional investors will tend to buy safer investment products if the market warrants, said Brown. Institutional shareholders are more apt to anticipate a market peak and use fixed-income products than are retail investors, so there is less movement when things turn sour, said Brown.

"I certainly would assume that institutional investors, over the course of the last year, have moved money into fixed-income products in anticipation of interest rate cuts and market volatility," he said.

All Engines Reverse

Conversely, while September was the worst month ever for equity funds in terms of net outflows, early reports for October suggest that equity funds are experiencing net inflows. "I would imagine that a lot of the money that moved into equity funds the last week or two was from institutional investors--vs. retail investors who have sold just as the market has appeared to hit a trough," said Brown.

Not everyone agrees with the notion that institutional assets are stickier or, despite the flows, were less affected by the downturn. "This is not comparing apples to apples," said Avi Nachmany, director of research at New York-based Strategic Insight. "A lot of these comparisons don't tell you a whole lot. The problem is that much of the appearance of flow activity into institutional classes and funds is actually an extension of individual ownership."

For example, mutual fund wrap programs and defined contribution programs, such as 401(k)s, are classified as institutional assets, but are owned by retail investors. It stands to reason, however, that retail investors are less likely to touch assets in wrap programs or 401(k)s than they are traditional retail assets, but that does suggest that retail investors are not completely reactionary.

Difficult Patterns

According to Nachmany, there are too many variables to analyze the activity of retail vs. institutional. "You have so much mix-and-match that it's hard to say," he said.

There are platforms where retail investors are very sticky, such as those through disciplined financial planning professionals, and there are platforms where institutional assets can be quite volatile, he said. For example, institutional investments tend to be funded by a pooling of private accounts, and many times the movement between the private accounts and funds has nothing to do with what the market has done recently, Nachmany said.

Still, as the prolonged market downturn continues, mutual funds sales that are independent of what the market has done recently probably sound pretty good to fund companies.