The headlong rush of money into bond mutual funds bears all the distinguishing marks of a classic error in timing.
Bond funds are the only broad category that has produced consistently decent results over the past couple of years. As day follows night, people who wanted nothing to do with bonds during the runaway stock rise of the 1990s now can't get enough of them.
Through the first nine months of 2002, the Investment Company Institute reports, investors bought $119.8 billion more of bond-fund shares than they cashed in. That eclipses the full-year record for "net new cash flow" of $102.6 billion set in 1986.
The 2002 competition for best-selling breed of funds, as reported by Financial Research Corp. (FRC) in Boston, is a two-horse race between intermediate-term bond funds, which attracted $29.4 billion from January through September, and intermediate-term government bond funds, which brought in $22 billion.
We used to see numbers like these in technology and aggressive-growth stock funds as the Internet stock boom was peaking in 1999 and early 2000. Veterans of the game worry that buyers' timing is no better now than it was then.
"This extraordinary cash flow into bond funds raises red flags," says the Vanguard Group, the biggest U.S. fund manager as ranked by FRC, in a commentary prominently featured on the fund firm's Web site, www.vanguard.com. "Are investors buying bonds for their income and risk-dampening qualities, or are they simply chasing performance?"
To get a sense of the hazards lurking for newly minted bond bulls, one need only look at funds' October results, when the mood changed abruptly in both the bond and stock markets.
Municipal bond funds tracked by Bloomberg lost almost 2 percent and long-term government bond funds 1.9 percent. This came as the yield on the benchmark 10-year Treasury bond rose from 3.6 percent to 3.9 percent, driving bond prices lower.
While one month doesn't make a trend, we could count on more of the same from funds investing in higher-quality bonds during any sustained rise in interest rates.
Bond-fund investors have a long-standing reputation for buying heavily at the wrong time. The three biggest years for inflows into bond funds in the 1990s were 1992, 1993 and 1998. The two worst years for bond-fund performance in the '90s were 1994, when the Salomon Brothers 10-year Treasury index fell 7.6 percent, and 1999, when it dropped 8.7 percent, according to Bloomberg.
That mistake, known as "performance chasing," is stoked by the powerful impulse in the human psyche to invest in whatever has been doing well. Trouble is, today's money can never buy past performance, and in an economy prone to cycles, tomorrow's results in bonds are often the opposite of yesterday's.
Big as this problem may be, it is not the whole story in bond funds -- which many people use not as a timing vehicle of any kind but as a long-term investment boasting several attractive properties. Bond funds can be good sources of income, plus valuable diversification that lends stability to one's investment plan.
Looking in that long-term light, we might view recent flows into bond funds as a move to right an asset-allocation imbalance that arose during the 1990s and needs fixing now.
A decade ago, the Investment Company Institute numbers show, fund investors tended to keep their money in roughly even proportions -- a third in stocks, a third in bonds, a third in money markets. By the end of the 1990s the proportions had tilted drastically, and bond funds' market share had shrunk to a meager 12 percent. Stock funds had five times bond funds' assets, money funds more than twice as much.
Now bond funds are back up to 18 percent. It's anybody guess whether that share will keep rising, or what an appropriate "equilibrium" amount would be. Maybe not 33 percent again, but surely more than 12.
Ideally, as an investor you'd like to rebalance ahead of market moves rather than in their wake. In real-world investing, though, you usually have to settle for less than the ideal.
If fund investors' short-term judgment is flawed, they still may have made an adjustment in the longer-term allocation of their money that's quite appropriate to the age in which they live. Timing isn't everything.