Scrapping U.S. Stock Funds for ETFs

While the level of fear and uncertainty in the stock market has subsided quite a bit, investors are still rather gun-shy. So much wealth was lost in the latest market downturn that folks are likely to view Wall Street with a wary eye for some time. And, perhaps not surprisingly, investors are continuing to punish one particular segment of the market.

Stemming the tide
According to Morningstar data, investors continued to pull money from domestic stock funds in February, almost a year after the market hit its lows. While every other major asset class took in money last month, investors pulled roughly $3.7 billion from U.S. equity funds. Over the past 12 months, a whopping $21.3 billion has made its way out of stock funds, mostly into the perceived safety of bond funds. Investors have also been boosting their allocations to international stock funds, to the tune of $4.6 billion last month alone.

More notably, one area of the domestic equity market managed to buck the trend of outflows in February: exchange-traded funds. Investors actually added $4.8 billion to domestic stock ETFs last month, far more than any other asset class -- even bonds. If actively managed domestic stock funds are the new black sheep of the market, then ETFs are the place to be now.

Throwing in the towel
Of course, one month of data doesn't prove too much, but February's data underscore a longer-term trend -- investors are shunning actively managed funds and stuffing their money into passive equity vehicles. I think that neatly highlights investors' dissatisfaction and disillusionment with active managers. After all, if you're paying the extra fees for an investment guru to manage your money, you expect some added benefit. The vast majority of active managers didn't anticipate the recent market meltdown, and even underperformed broad market indexes in that time. So it's little wonder that investors are giving up on outperforming the market and sticking to low-cost exchange-traded funds.

But ETFs are not without potential dangers. While they are generally much cheaper than actively managed funds and can be more tax-efficient, investors need to make sure they're sticking to the right kind of ETFs. Funds that invest in one specific segment or region can lure investors with their outsized returns during certain times, but these offerings are typically much riskier and more expensive than more diversified fare. If you're a fan of ETFs, make sure you're buying broad market funds like these:

Source: Morningstar Principia.

You might be tempted by a triple-leveraged inverse fund that invests in the Chinese market, but this fund is more suited to gambling than investing. Stick to low-cost, well-diversified funds if you're going the ETF route.

Don't chase your tail
There's another lesson to be learned from investors' shifting loyalties -- the danger of chasing performance. Most folks are primarily reactive investors, adjusting their portfolio and their approach in response to the market's movements. That's why billions of dollars have been yanked from stock funds and moved into bonds. Of course, these moves are made too late to do investors any good, because they've already lost money in the bear market, then missed the rebound because they were out of the market.

Similarly, much of the $4.6 billion that moved into foreign stock funds in February is likely chasing the returns of the red-hot emerging markets category. Emerging markets have posted a roughly 75% return in the past year, which has attracted a lot of attention. And while I believe the long-term outlook for emerging markets is quite strong, people forget that this asset class is also notoriously risky and subject to wide swings. Make sure you've got a decent allocation to emerging markets for the long term, but don't overload your portfolio with these stocks just because they've been on fire.

Lastly, don't be so quick to count the U.S. market down and out. I do think that the market is probably pretty fully valued right now and that general returns may not be impressive this year. However, there are pockets of opportunity and areas that should outperform in the near future. I think financially stable blue chips are due for a comeback. Stocks that pay decent dividend yields are also likely to be winners, so think about allocating some new money to a dividend-focused stock fund or ETF.

Keeping your focus on the long-term picture can help you ignore the short-term performance-chasing going on all around you.