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Part of the Herd But few are able to point the finger at any one particular group as blameworthy for the rise and fall. A recent study by Harvard Business School professors Erik Stafford and Joshua D. Covel has found that mutual funds may be the culprit and the forces they exerted on the markets leading up to the bubble burst are still at play.
The two suggested in their report called Asset Fire Sales (and Purchases) in the Equity Markets" takes a detailed look at how mutual fund managers react to certain market events based on cash inflows and outflows. The belief that mutual fund managers were "forced" to cover themselves in the event of poor performance and spend money on stocks when they did exceptionally well was often thought of as fund specific. It turns out that their moves had a wider effect on how the markets move than previously thought.
Mutual funds that are expecting a poor performance for the quarter will often anticipate that the shareholders in the fund will flee for some other better performing fund or sector. This "voting with their feet" effect can be felt when the fund is forced, in a fire sale, to sell large quantities of stocks to cover the redemption of the funds shares.
Because investors in poor performing funds see no reason to hold on for better days, they want their money and they want it now. Most equity mutual funds, often by their own charters, keep very little cash on hand in favor of full investment of available funds. So to raise money to pay the exiting shareholders, the fund must sell some of their holdings. Until this report, it was unclear just how much of an effect this was having on a specific sector or, in some cases, the overall market.
On the flip side, funds that have had stellar quarters, have found themselves flooded with inflows of money as investors seek to hitch themselves to the rising star. This sudden spike in cash reserves must be spent - once again because of the relatively small percentage of cash fund's are permitted to keep on hand per charter rules - forcing the fund manager must buy additional stocks. While some funds, overwhelmed with money and relatively few good buying opportunities will close their doors, it often takes up to a full quarter to do so and by then, it may be too late.
The professors called these fund events as forced purchase. The result of this type of buying in the open market, often targeted at a specific sector, push the prices higher until someone sounds the warning and the whole sector crashes. In some cases, the overpricing effects the whole market place and the professors point out, this may have been the reason for the crash in 2000.
While one large fund may not have the power to bring down a whole sector, the movement is seldom isolated as the underlying stocks sudden change in value alert other holders of the equity which, by coincidence, happen to be other large funds to buy or sell as well. Anticipation of missing a run-up in price or failing to recognize a potential fall forces other funds to begin to react. I mentioned several columns ago that there are forces at work in the marketplace that are governed by program trades. These computer driven buy/sell programs allow fund managers to put some stocks in their portfolio on autopilot. These programs react to one fund's fire sale or forced purchase by jumping in automatically and buying the same or similar stocks.
Individual investors will seek to profit from this movement at their own risk. The holdings of a mutual fund are often several months old by the time they are made public. Buying the holdings of a top performing fund in the hopes that the stocks in the portfolio will rise based on the manager's forced purchases runs the risk that the stocks will become, in the market's mind, overpriced. Chasing the fire sale that happens at poor performing funds, the individual investor will try to short the beaten down shares of the fund. The market might also work against this thinking as the shares of the stocks the fund has sold begin to reach a bottom and become a sudden value.
The best way to benefit from this kind of fluctuation is to pick top performing funds whose managers have proven their expertise over a long period of time (five years) and are actively managed. For those who prefer indexing, the diversity does provide a good deal of safety from these fluctuations. For instance, the Dow jones Wilshire 5000 index has returned an average of 12.4% over the last twenty five years.
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