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Hot Mutual Funds Are Great Contrary Indicators

Eleven years ago, I clipped a full-page advertisement out of Barron's for the Munder @Vantage fund, a high-profile mutual fund launched in 2000, just months after what we now know was the market peak.

What struck me back then about the fund -- and the ad -- was that after years of watching the Nasdaq soar, Munder had finally taken every fear, objection and doubt about investing in technology and turned it into a perceived benefit. The fund itself ended up being a great contrary market indicator: It was only possible to sell such a product after the top had been hit.

For most of the 1990s, investors, many of whom were nervous about impossibly high valuations and uncertain business models, actually avoided technology stocks. It was only when the “future” arrived, when the reality of how significantly the Internet would impact our lives became readily apparent, that the herd finally felt comfortable paying 99-times earnings for Cisco (CSCO: 23.69*, +0.08, +0.33%), or threw money at a fund as ridiculous as Munder @Vantage.

The fund's very name was in hindsight an obvious red flag. Including the "@" sign (still a relative novelty back then, with U.S. Internet penetration under 45%) suggested the fund was unabashedly forthright in its quest. By 2000, the Internet millionaire was a cultural icon and national obsession. We had seen Yahoo’s (YHOO: 16.45*, +0.05, +0.30%) Jerry Yang, CMGI’s David Wetherell and TheGlobe.com’s Stephan Paternot make fortunes from Internet investments. This fund was the everyman's way in the door. The "@" was the only sign that mattered.

The fund's advertising featured a disclaimer parodying government warnings on cigarettes, cautioning the fund wasn't for the "namby-pamby, lily-livered, scaredy cat." It was a direct jab at the then-humiliated value investors who had missed the technology boom. The @Vantage fund celebrated its riskiness: "Investors who are weak-kneed, incessant nail biters, prone to fainting spells or dizziness, tend to stay up at night worrying, or have serious qualms, hysteria or neurosis should not consider this fund," teased the copy.

And at a time when most mutual funds had a $1,000 or $2,000 minimum, Munder @Vantage required a $10,000 investment, charged a 4% initial commission and levied a 3% annual fee. Back then, nobody cared. After all, we were all going to be rich.

Munder baited interest, selling the fund as a "limited time offer" and promising to refuse new investors after a date prominently featured in the ad, which it did, but not before raising $200 million. By then, technology stocks were already 30% off their peaks and headed much lower.

I've often noted how investors should be attracted to illiquidity. Oftentimes, the exposure you should want is exactly the one that's most difficult to achieve. Because mutual funds are created to be sold, by the time a host of investment products have been rolled out to capitalize on a move, there's usually a good chance that it’s already been made.

I don't pick tops. But in today’s market, one must be cognizant that many of the so-called alternatives like commodities and foreign currency have now become resoundingly mainstream, as evidenced by recent mutual fund flows.

With $54 billion dollars in assets, for example, SPDR Gold Trust (GLD: 131.00*, +0.15, +0.11%) owns more gold than the Swiss National Bank. But back in 2001, beyond a few oddball closed-end funds trading at wide discounts to their underlying net-asset-values, it wasn't easy for most investors to include commodities or emerging markets in a traditional stock portfolio. Products like iShares MSCI Emerging Markets (EEM: 46.42*, -0.11, -0.23%), iPath Livetock ETN (COW: 29.48*, +0.10, +0.34%) or WisdomTree Commodity Currency Fund (CCX: 25.43*, -0.21, -0.81%) simply didn’t exist.

Now, they are some of the public’s top choices and, as we pointed out a few weeks back, are now largely positively correlated with the very stock indices investors had originally sought to hedge.

Truth be told, most people actually don’t want to take investing risks. Not wanting to look foolish or lose money, they're comfortable investing only after the uncertainty of a risk has been legitimized, either in a book such as the now infamous Dow 40,000 or in a fund like Munder @Vantage, which served the entire promise of the Internet boom on a plate only after five years of stunning gains. At the time, only an idiot would have passed on the opportunity to get on board.

By 2007, seven years after the ad ran, a $10,000 investment in Munder @Vantage would have been worth $3,932, a loss of 60.7%. The fund was ultimately folded into Munder Internet Fund, now known as Munder Growth Opportunities (MNNAX). The dream was dead before it even began.

We observed that equity prices tend to fall after equity exchange-traded funds (ETFs) rake in large sums of money. Conversely, the market tends to rise after equity ETFs post heavy outflows.

Regression analysis suggests the probability that equity ETF flows are not a contrary leading indicator is less than 1%.

Monthly equity ETF flows (as a percentage of assets) and the returns of the S&P 500 one month later are negatively correlated to the tune of 21.4%.

The negative correlation rises to 45.6% for a two-month period, and to 52.4% for a three-month period. The correlation coefficients are statistically significant at the 1% level of confidence in all cases.

Short equity ETF flows are positively correlated with future stock returns, and these correlation coefficients are also significant. Simply put, ETF investors are exceptionally poor market timers in both directions.

We built a simple model that goes long the S&P 500 when equity ETF flows are below average, and short when they are above average. We tested it with moving averages of 1 to 100 days. The contrarian ETF portfolio significantly outperformed the S&P 500 in all cases, with average gains of 281 percentage points in the past decade. The outperformance was strongest for smoothing periods of one to four months.

We have two explanations for the strongly negative correlation between equity ETF flows and future market returns. First, ETFs are traded mostly by retail investors and day traders. These are the least informed and most emotional market participants—the ones most likely to lose money over time. Second, we suspect hedge funds use ETFs when liquidity dries up.