Will Investors Keep Shunning the Market?

A look at investor behavior following the flash crash

By + More

The flash crash has claimed another victim: mutual funds’ pristine inflow streak. During the week that started May 6, the same day as the market’s 1,000-point intraday plunge, investors yanked a net total of $14 billion out of long-term mutual funds, the Investment Company Institute reported on Wednesday. The last time that mutual funds had net weekly outflows was in March 2009.

[See U.S. News's list of the 100 Best Mutual Funds for the Long Term, and use our Mutual Fund Score to find the best investments for you.]

During investors’ weeklong exodus following the flash crash, they punished domestic equity funds, withdrawing a total of $8.6 billion from them. But the bigger story is that bond funds, for the first time since late 2008, saw net weekly outflows, and over the course of the week, investors pulled $989 million out of them.

That investors fled stock funds is hardly surprising. Even during the height of the recovery, many investors showed signs that they didn’t have much confidence in the market’s ability to sustain its returns. For instance, during the 52-week period immediately after the stock market bottomed out on March 9, 2009, the S&P 500 gained roughly 70 percent. But during that same time period, investors actually yanked more money out of domestic stock funds--$8 billion more--than they put in.

Bond funds, on the other hand, had become accustomed to preferential treatment from investors even during periods of uncertainty. But the flash crash, coupled with concerns over the sovereign debt crisis in Europe, changed that as investors not only abandoned riskier stocks but also shunned the supposed safety of the bond market.

“I think people just abandoned risk,” says Paul Schaeffer, the president of the mutual fund research firm ReFlow Management. “I worry that there’s no discrimination; it’s like they’re reliving last year and just deciding, ‘I want to be out of any asset that has risk.’” Unsurprisingly, then, the big winners in the week following the flash crash were money market funds. The funds, which the ICI counts separately from long-term mutual funds, saw $24.2 billion worth of inflows during the week starting May 6 as investors parked their money in cash.

If the recent outflows become a pattern, funds could find themselves facing some problems. “You have volatile markets and you have shareholder redemptions,” says Schaeffer. “It’s sort of the worst of all worlds for a fund manager.”

Still, Christine Benz, Morningstar’s director of personal finance, cautions against interpreting the flows as a sign that jittery investors will plague the market in the months to come. “A one-week period is hard to draw meaningful conclusions about,” she says. She also points out that even during tumultuous periods, high volume by active traders tends to mask the broad swath of long-term investors who sit still. “A lot of investors probably wouldn’t [have] responded at all to the flash crash,” she says. “It’s hard to say that investors wholesale have lost faith in stocks or bonds due to the flash crash."