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Equity Funds Take in $220B in 2004 But Industry Loses $34B Overall

A lackluster December in mutual fund sales closed the curtain on a year that wasn't overly dramatic for the industry, according to fund tracker Lipper of New York. While the S&P 500 rallied by 3.4% in the final month to help deliver a solid, 11.5% gain for the average domestic equity fund in 2004, fund flows sputtered in December as investors turned their attention to the holidays.

All told, funds lost $34 billion during the year. Equity funds took in $220 billion, but bond funds saw $14 billion in net outflows and money funds saw $240 billion drain away. The good news for the industry, however, noted Lipper Senior Analyst Don Cassidy, was the strong flow into equity funds, marking a "clear improvement in revenue mix" because of the funds' higher fees.

"Estimated inflows into equity funds from retirement-plan accounts in the workplace probably accounted for about 60% of the $220 billion overall inflows into such funds, so it is clear that mutual fund investors were by no means overly excited about the market in terms of its driving them to write lots of checks into their taxable accounts," Cassidy said.

Cassidy cited a prolonged period of frustrating sideways and slightly downward price trend as a reason for investor reluctance. For example, flows were fairly strong in those months when stock prices were rising most sharply. In fact, he noted, January 2004 enjoyed a new all-time single-month record for flows to equity funds, narrowly beating the prior peak set in February 2000.

Net flows into red-hot exchange-traded funds were about $50 billion in 2004. While they continued to gain market share, they account for less than 3% of conventional fund industry totals and a whisker over 4% of non-money fund totals.

Due to their "clean reputation, ETFs benefited to some degree from switching from funds as a response to the trading scandal, [as well as] from strong marketing and rising awareness, from their low expense ratios and from their all-day transacting ability," Cassidy said.

By comparison, conventional index funds enjoyed net inflows of $62 billion in 2004. Excluding January, when older-style index funds had a very large inflow, the two competing types ran essentially a cumulative dead heat in flows for the subsequent 11 months, Cassidy observed.

Looking back on the year, Cassidy expressed a degree of satisfaction over the industry's performance in the face of external events. Impact from the trading scandal persisted, he added, but investors returned to equity funds because the bull market continued. Net inflows, however, relied heavily on the strength of workplace retirement plans.

"The bad news is that investors have not been buying funds in large amounts based upon current decisions, despite a sanguine market climate," Cassidy said. "The good news is that they yet show no signs of over-exuberance, although a few small pockets of strong inflows might raise concern.

And while ETFs, separately managed accounts and hedge funds continue to pose challenges, the bulk of middle-American households still choose conventional mutual funds as their primary investment vehicle. As such, Cassidy is appealing to the industry to further educate the general public on the benefits of consistent investing, rather than to buy high and sell low. The upcoming debate over the privatization of Social Security could provide the appropriate platform, he said.

"Although we doubt the fund business will get a piece of the action in the near term, it can do a major, visible public service by raising its education efforts even in the absence of prospective immediate self-interest," Cassidy said.

A Cautionary Tale

In December, investors added an estimated $12.4 billion to equity funds, which was roughly half the inflow they enjoyed during the previous month's post-election enthusiasm. Bond funds bled $2 billion and money-market funds drained $5.5 billion.

"Even allowing for the usual holiday lull in net flows, the results were a bit disappointing considering short-term performance," Cassidy said. "We continue to see strong selection bias toward safe-feeling fund types and little overall sustained enthusiasm."

U.S. diversified equity funds, which have about 64% of total equity fund assets, were also on trend in December, posting small net inflows of less than $1 billion. Sector funds continued to reflect investors' lack of confidence about making rifle-shot choices, Cassidy said, and witnessed an outflow of $1.7 billion, despite inflows to real estate and natural resource funds.

"Investors could hardly be described as excited or manic," Cassidy commented. "With $6.2 billion of net inflows, the mixed-equity fund types took in half the overall equity funds' flows as current income in hand retained its strong hold on taste."