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Investors Showing Strong Aversion to Risk

The bear market and scandal have left a scar on American investors, as many seem to be following a trend of averting risk - which is understandable considering the amount of wealth that vaporized - and investing in a cluster of conservative funds that have been attracting approximately 50% of the total net flows.

In fact, net flows have become increasingly volatile from month to month, driven by short-term movements in the markets, and only a few brands have been attracting most of the net flows since the scandal began. This is according to a study by Lipper of New York, called "Slow Flows: Where Investors' Money Is and Isn't Going."

Investors have been shying away from mixed-equity funds and focusing on value and income-oriented equity funds, including pure income, balanced, real estate, utility and equity income. The long-favored growth style has been in persistent net redemptions, and the only traditional equity categories that have shown staying power over the past three years have been international and lifecycle and lifestyle funds.

As to why investors have become so selective, Lipper believes the bear market has had a strong and lasting impact. "Memory of pain is a stronger driver than hope for pleasure, at least until a considerable time has passed," according to the report. "Investors act to seek comfort and avoid discomfort," and as a result, they have been chasing performance.

As an example of the adverse effect of pain, equity funds had a negative outflow of $19.7 billion in the market-bottoming year of 2002, but did a turnaround in the sharp recovery year of 2003, attracting $184.2 billion. The appetite for equity continued into 2004, driven by moderately good returns in the first two quarters, with equity funds taking in a total of $220.6 billion. But with the market faring less well this year, equity funds have taken in only $130.5 billion in the first 10 months of this year, a decline of 28% from the year-earlier period.

While performance is a major driving force behind net flows, real estate has also diverted billions of dollars away from the stock market. The fact that people spend more than they save and that the net savings rate is roughly 0% is another significant factor slowing mutual fund flows.

Further, the market-timing and late-trading scandal has also had an impact on the industry. While it cannot be measured, Lipper notes, the fund brands most negatively and frequently named in connection with the scandal have been "profoundly affected" and have suffered huge outflows month after month.

Conversely, a handful of brands have become immensely popular since the scandal, and have taken in more than 50% of the industry's net flows. Such "trusted brands" include Capital Research Management, Fidelity Investments, T. Rowe Price, and Dodge & Cox.

"It has been widely conjectured that some investors may have abandoned not just the brands that were publicly named, but perhaps conventional funds in general. This may have been a contributor to the patterns shown," according to the report.

So if traditional mutual funds are waning in popularity, where is the bulk of investors' money going? The answer is quite simple: exchange-traded funds. Institutional investors - including externally domiciled investors, hedge funds and other types of participants that normally would be unlikely buyers of conventional mutual funds - have been attracted to ETFs for a few reasons, including the creation of new shares and a considerable marketing push.

In the first 10 months of 2005, equity funds have taken in $104.9 billion and ETFs have reaped $33.2 billion. By comparison, traditional equity index funds have seen $18.4 billion in net flows. Today, ETFs hold 12% of all equity fund assets. "ETFs are gaining some mind and market share and in recent years have had better flows than traditional equity index funds," the report notes.

As for broadly diversified equity funds, which held 75% of all assets in stock funds in 2000 and represented 90%-110% of net flows into equity funds during the bear market years of 2001-2002, their percentages have collapsed to the point that they are experiencing a small net outflow this year. Instead, specialty funds have taken center stage. Lipper believes diversified equity funds have waned in popularity because the largest holdings in such funds have been in growth and large-cap funds, which suffered the greatest losses in the bear market.

While some investors have sought the safety of value, income and balanced funds, others, interested in growth and basically betting against the U.S. economy and the broad domestic market, have been investing in international equity, real estate, natural resources, utility and gold funds. In fact, the popularity of these types of inflation-hedge and anti-dollar funds - when grouped together as a single category - has grown dramatically in the past five years, the Lipper report shows.