No Redemption: The Scenario in Which Tech and Growth Sectors Get Much Bloodier
By Ian McDonald
Senior Writer
3/2/01 12:09 PM ET
URL: thestreet.com
The dollar you put into that tech fund a year ago is worth less than 50 cents. But if money starts gushing out of growth and tech funds, you might be left with a bright shiny quarter.
Yes, the average tech fund is down some 56% over the last 12 months, according to Morningstar. But most investors haven't yet started yanking money out of the tech and growth funds that bet the farm on the sector. If or when they do, things could actually go from awful to much worse if recent history is any guide.
In 1998, cash began streaming out of tech-light value funds and gushing into better-performing tech-heavy growth funds. Value fund managers were forced to sell stock to meet nearly $90 billion in redemptions over the next two years, essentially sinking their own picks and perpetuating a vicious cycle where sagging returns begat high redemptions, which begat even worse returns, and so on.
The bottom line: Fund flows follow performance. So if growth and tech funds don't bounce back soon, their leaking coffers could add a lethal dose of selling pressure to their already battered holdings.
"I think the probability is very high that growth funds will be hit with big redemptions as this year goes on," says Scott Cooley, a senior fund analyst at Morningstar. "I think it's definitely possible that we'll see the same phenomenon in growth funds that we saw in value funds. There is clearly more hot money in these growth funds so it's not hard to imagine the situation being just as bad or worse."
Even growth managers, a cheery bunch in recent years, admit that redemptions could shake their stocks if things don't look up soon.
"It's definitely possible," says Jeff Van Harte, portfolio manager of the large-cap growth Transamerica Premier Equity fund. "I think it hinges on whether or not the market stays down. I think we're in for a meaningful recovery in the fourth quarter. If that happens I think it won't be too bad, but if the market stays down then [redemptions] could be a problem."
Flows to growth funds have been nothing short of stunning in recent years, including last year when the Nasdaq Composite's nearly 40% fall hit these funds hard. It takes time for fund investors to switch gears, so growth funds had net in-flows of $192 billion last year, compared with a net outflow of $49 billion for value funds in 2000, according to Boston fund consultancy Financial Research Corporation. But January's flows showed a growing appetite for less aggressive and less tech-heavy funds and if that trend continues it might be time to brace for those billions' exodus from the Nasdaq and tech sector.
A Lesson From Value
It's hard to say that vast fund redemptions can single-handedly sink a sector, but they certainly don't help. While the average big-cap value fund lagged behind the S&P 500 narrowly from 1995 to 1997, the benchmark began lapping these funds once investors started shifting money to growth funds in droves.
Before taking the reins of the Oakmark fund from his frustrated colleague Robert Sanborn last March, veteran fund manager Bill Nygren watched redemptions ravage the fund and its holdings.
"We peaked at $9.8 billion in April 1998 and last March we were at $2 billion," Nygren says. "The story you'd hear from many value managers is similar, if maybe not as large. We had $9.8 billion worth of stocks we thought were attractive and despite our belief that we thought they were attractive, we had to sell $7 billion worth of those stocks. We had to sell them every day."
The Oakmark fund matched its peers with a 3.7% gain in 1998, but lost 10.5% in 1999, trailing the S&P 500 by more than 31 percentage points and almost all of its peers, according to Morningstar. Nygren says the fund was still losing $20 million per day early last year, but has seen consistent in-flows this year. The fund is up 9.1% since Jan. 1, beating the S&P 500 by almost 15 percentage points and 98% of its peers.
Nygren thinks steep outflows among growth funds could sink tech stocks and other growthy fare because, unlike many value managers' favorite financial stocks, many of these companies won't be willing or able to mount share buyback programs. He thinks the Nasdaq's free-fall won't end before growth fund investors vote with their feet, even though it's already down over 50%.
"Something can lose half its value in 12 months and still not be statistically cheap. We still haven't had much redemptions in the growth area and it's hard for me to believe this will end before that happens," he says.
And that hasn't happened -- yet. Even though the average big-cap growth fund is down more than 26% over the past 12 months, money is still gushing into the funds.
But cash flows to growth funds are starting to slip. In January, typically a big month for in-flows due to rising 401(k) and IRA contributions, big-cap growth funds took in $4.9 billion, or about half of last year's monthly average, according to FRC.
Some notable and sizable growth funds are already losing ground. The $5.9 billion American Century Select fund, for instance, was in net redemptions to the tune of $404 million last year despite decent performance relative to its peers, according to FRC.
Janus, the Denver growth shop with massive stakes in growth favorites like Nokia(NOK:NYSE ADR), AOL Time Warner(AOL:NYSE) and Cisco Systems (CSCO:Nasdaq) among others, has consistently been in net redemptions since closing several funds to new investors last year. The firm has $172 billion in its retail stock and bond funds, but lost some $1.3 billion to net redemptions in December and January, according to FRC.
At the same time, investors do seem to be turning back to value funds. Data from fund-tracker Lipper indicate they took in $7.7 billion in net new cash in January, their biggest one-month in-flow in three years, according to New York fund consultancy Strategic Insight.
If growth funds eventually have to sell stock to raise cash and meet redemptions, it's hard to say the tech sector won't be hurt. The average growth fund has almost 38% of its money in tech stocks. That's steep compared to a 23.7% tech weighting in the S&P 500, a common benchmark for the market.
Mainlining Tech
If growth managers have to sell stocks to meet redemptions, tech will feel the burn
Fund Category % Assets in Tech Stocks YTD Return
Large-Cap Growth Funds 39% -11.6%
Mid-Cap Growth Funds 40.2 -12.5
Small-Cap Growth Funds 34.1 -9.8
S&P 500 23.7 -6.1
Source: Morningstar. Holdings through Jan. 31 and returns through Feb. 28.
The situation looks even more ominous if we consider the shellacking tech stocks will take when investors' tech-fund fever cools further. That's already starting to happen in the wake of record inflows and breathtaking losses for the funds, which invest essentially all of their money in tech stocks.
Last January, tech funds took in $9.5 billion in net new cash and last month they took in $500 million, according to Lipper. In January, investors yanked more than $800 million out of the $9.7 billion T. Rowe Price Science & Technology fund, according to FRC. Rising cash flows to bond funds and value funds indicate a broad migration toward the lower-risk end of the fund spectrum and away from high-octane sector funds.
What Could Stop Redemptions?
"January [2001] flows do show that the tide can turn quickly," says Bob Turner, manager of the mid-cap growth Turner Top 20fund. "The bottom line is that [redemptions] could be a problem, but it really depends on the market and whether we're in the same position a month from now."
Aside from a rebound for tech stocks, what could stave off redemptions? Well, once an investor is down 50% or so, he or she often sticks to their guns figuring things can't get much worse. Still, redemptions could also be driven by a little prudent rebalancing. Tech funds got about a third of all fund flows last year, so a lot of investors will probably sell just to bring their portfolio back to reality. Given their huge tech bets, it wouldn't be surprising if that alone helped drive tech stocks further down.
"I'd say that's a solid theory and that's why people follow fund flows closely. It's a $7 trillion industry and it can move the market," says Dave Haywood, a consultant with FRC. "The money is essentially all in growth and a good portion of that money is in technology. People are seeing poor performance from their growth funds and realizing they need to rebalance their portfolios."
While rebalancing might be part tech's problem this year, it's probably part of the solution for over-teched fund investors. We've talked about reducing tech exposure before, the upshot being that too many people making big bets on one pocket of the market is precisely what led to this mess. Unwinding this tech overdose will probably deepen the pain in the short term, but for long-term investors, it's probably worth the effort. |
