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Equity Fund Flows Show Cautious Optimism

Investor confidence in the financial markets is slowly improving, as a recent report showed equity mutual fund flows hit their highest level in more than a year.

Investors added an estimated $19.5 billion to equity funds in June, according to Denver-based fund-tracking firm Lipper. That represents the largest monthly inflow since the nearly $29 billion inflow in March 2002. Overall, mutual funds took in $44 billion in assets in June. Still, the buying was not overly optimistic, as the types of funds chosen for investment reflected what Lipper described as "broad underlying caution."

Among individual sectors, real estate offerings captured more than half of the overall sector-fund total, signaling ongoing caution among fund shareholders. As a whole, sector funds notched a mere $0.6 billion in inflows, a modest increase from $0.4 billion in May. Gold, telecommunications and financial services recorded small outflows, while health, biotechnology and natural resources posted minor net gains. Typically, sector bets indicate an aggressive investment approach, the report noted.

Mixed equity funds remained an attractive choice among investors, tacking on $6.9 billion, up from $5.5 billion in March. These funds often feature a prominent level of income or some sort of safety component. Within the mixed equity group, income funds led the pack, taking in $2.9 billion. Balanced funds took second place, amassing $2.2 billion. Convertible securities funds managed to capture $300 million in June despite fierce competition from new closed-end initial public offerings, more than a 3% increase from their prior month-ending total assets.

U.S. diversified equity funds ranked first in net inflows, taking in $9.9 billion. However, the numbers are not that impressive considering the group makes up more than 60% of all equity-fund assets. Value funds maintained their dominance over growth funds, having garnered more assets for the 29th month in the past 30 months. Growth funds netted $2.8 billion, marking only their fourth time in positive territory in the last 24 months.

"That's hardly an overwhelming show of commitment or confidence, considering the sharp rally from last year's lows," said Don Cassidy, senior research analyst at Lipper.

From a capitalization vantage point, multi-cap funds added an impressive $4.9 billion to their total asset base, suggesting that buyers lack the conviction to make a definitive choice in asset class. World equity funds garnered $1.1 billion in June, reversing outflows of $1 billion in May. But again, investors' decisions seemed to be based on uncertainty about the U.S. equity market's prospects or past performance, the report said.

Indeed, international funds collected $0.6 billion, and emerging markets funds added $0.5 billion. Global funds, which include up to 25% of U.S. holdings, lost $150 million in June. Meanwhile, Pacific ex-Japan took in $100 million, possibly signaling strength in Korea and China.

Elsewhere, money market funds registered their first monthly inflow since November 2002, posting $18 billion in gains and reversing a streak of four straight Junes in negative territory. On average, money funds hemorrhaged $28 billion in June between 1999 and 2002.

On the fixed-income front, bond funds declined for the fourth straight month, taking in $6.5 billion, a far cry from the $9 billion they amassed back in March and their lowest level since losing $6.4 billion in October of last year. Funds focused on shorter-term bonds brought in a bulk of the new money, with $4.4 billion in new assets.

Government bonds relinquished a net $0.5 billion in assets as losses sustained at long-term offerings offset a modest pickup in short-term municipals. Lipper believes that the exodus from bonds into equities can be attributed to a combination of fear of rising interest rates and investors putting cash to work in stocks in hopes of generating stronger returns.

"If mid-June highs in stocks represent the top of a strong interim rally, capitulation away from bonds would be consistent with behavioral finance adherents' expectations of the crowd swinging late in a move," Cassidy said. Essentially, they would be chasing past performance.

In terms of his near-term outlook for the market, Cassidy believes a test for the major stock averages in July would be a telling sign of whether a recovery on Wall Street is, in fact, underway. "A flat or lower month for stocks could provide a reality check for investors as well as for the asset management industry's expectations," he said. "Such a month would provide a better laboratory than a third month of a sharp rally, in assessing fund flows' durability."

Another report released last week by Strategic Insight showed long-term fund inflows exceeded $100 billion during the second quarter. That marks only the fourth time in history that quarterly mutual fund assets topped the century mark, according to the New York-based research firm.

"What's remarkable in the recent data is that improvements in [the] industry's cash flows have been triggered not by speculative exuberance; instead we have observed small incremental gains across many investment strategies, funds, management companies and distribution channels," said Avi Nachmany, director of research at Strategic Insight.

"Leveraging this stable, not euphoric base, and assuming investment confidence remains favorable during the second half, the mutual fund industry would experience even faster growth in coming months."

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