Mutual fund retention rates jumped to record highs over the last two years, a sign that "smart" investors have been the driving force of the recent bull market.

Boston-based Dalbar's "Quantitative Analysis of Investor Behavior" reveals that investor retention of equity funds remained at a record 4.3 years in both 2005 and 2006. The recent record is markedly higher than retention rates over the last 20 years, which mostly hovered around three years in length over that period, and as low as 1.7 years in 1987. This may be in part a result of the growth in asset-allocation funds, said Dalbar President Lou Harvey.

"Most investor transactions you see are not attempts to rebalance [the fund allocations] but attempts to escape losses. When you have an asset-allocation fund, the investor is taught that swings in the market are being handled by the professional manager, so they don't have to jump in and out," Harvey said.

He added that management fees on asset-allocation funds have dropped enough so that they are comparable to regular funds-another factor prompting investors to hold.

Phil Nguyen, a financial adviser at Addison Avenue Partners, a subsidiary of the Addison Avenue Credit Union of Palo Alto, Calif., servicing Hewlett Packard and Agilent Technologies employees, said his asset-allocated customers saw their portfolios drop 5% to 10% during the last downturn.

"Most people who [invested in asset-allocation funds] have tended to retain their investments more. Traders were down 50% and never really got back in [to the market]," Nguyen said.

Nguyen, who typically places customers with less than $50,000 into asset allocation funds and allocates the assets of larger accounts himself, hit on another factor that appears to have lengthened fund retentions: The investors still in the market stuck it out through the tough times, while those that bailed out during the bear market are still mostly waiting on the sidelines.

"Therefore, the ones who lost money are out and the ones who stayed are showing very good returns because of what the market has done since 2003," Harvey said.

Steve Amarante, president of Infinex, a Farmington, Conn.-based third-party marketer, said that although his firm doesn't track fund retention levels, he is not surprised that investors are holding onto mutual funds for longer periods. "Anytime people go through some type of correction, they get smarter and they understand better what makes up the market," Amarante said.

That understanding includes holding on to funds through the dips. It also helps that there just hasn't been significant stock market volatility over the last three years. That is until May, when the Dow dropped 4.7% and the Nasdaq fell 7.6% from their highs that month. But Nguyen said his customers are unlikely to sell on the recent dip.

"I don't get as many calls as I did in the past when markets dropped. People don't panic as much," he said.

Nguyen acknowledged, however, that extended volatility in the equity markets or a year or more of flat returns could shorten retention rates. In addition, after steady stock market gains since 2003 and less than stellar returns on traditional bank-sold investment products such as CDs and fixed annuities, the more conservative investors common in banks may choose to re-enter the equity market. And those investors tend to be more skittish.

Amarante said his firm has seen investors taking their money out of those bank products and looking for higher-return investments. "They went into fixed annuities or bank products, and they're just not getting the return. The markets have been up and down a bit but fairly consistent overall, and advisers out there are more comfortable talking about equities again," Amarante said.

Those types of investors, however, tend not to have the perseverance to ride out the bigger dips, and so they may dilute the retention-strong investors populating the equity markets today. "It may take a couple of years for that money to flow in, but it started last year. Over the next five years, we may see retention rates start to lengthen again," Amarante said. Alas, the re-entrance of the not-so-smart investors may portend poorly for the equity markets' performance going ahead.

Harvey noted two psychologies that all-too-often occur among those types of investors: "There is the fear the market will continue to go down when the market is already down, prompting them to sell; on the other hand, when the market is way back up, they get back in."

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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