An Detailed look into the Rydex Funds: Understanding Investor Behavior
There are numerous sources that provide mutual fund data. Newpapers provide columns of statistics and Lipper, a Reuters Company, routinely ranks mutual funds every quarter. In addition, there’s no shortage of options on the internet such as Morningstar.com for comparing one fund against another. Rankings abound and year-end summaries will be touted by many publications, but the most widely available resource for investors, are the lists. These “top ten” lists are the norm because with 8,200 mutual funds available, investors need help. But did you ever look beyond the basic performance data of mutual funds? Have you ever considered that just comparing Net Asset Values (performance data) may not be the best use of these data for selecting a mutual fund? Well, below are various charts of the Rydex family of funds. These charts do not emphasize which funds were the best performing from the perspective of Net Asset Values (NAV), but rather focus on investor behavior. These charts attempt to illustrate investor behavior over the last quarter by showing you where investors put their money rather than showing you what was the best performing investment. This difference is critical because investors often don't put their money in the best performing investments, because after all who has a "crystal ball". However, sometimes investors do get right. And while one could use this information to chase the hottest sectors from quarter to quarter, this is not the intention of this analysis. Plus, for those of you thinking about this strategy, there are many studies that show that this isn't the best strategy over the long term. This analysis is to demonstrate that you can glean mutual fund data in a different way to understand more about how investors are behaving and to use there past behavior to your advantage.
The subsequent charts presented walk you through some facts that aren't readily available to the average investor and hopefully help you to improve your understanding of market behavior. While the facts presented lead you to see how much money investors made, it also shows you how much money investors can lose before they reach "break-even". This is crucial towards understanding when investors will be more likely to leave the market. The point of understanding investor behavior is to anticipate their reactions at critical turning points in the stock market and to identify when previous lows will hold or fail. By attempting to quantify the profits and losses made from mutual fund investors, the amount of money that investors earn or lose is used as a proxy for quantifying the stock market's reaction. In addition, we can observe the behavior of investors in different situations and discover how investors respond to price movements. So how much money did investors make last quarter and what are they likely to do with it? Let's begin by examining the battle between the bull and bears.
Part I - Bull and Bear Fund Analysis
Rydex Funds Bull/Bear Funds Cash Flow. The Rydex Mutual Funds family is one of the few Mutual Funds that discloses its asset size on a daily basis and you have to wonder why the Securities and Exchange commission (SEC) doesn’t change the reporting rules so that investors can have greater access to this information. There are many industry leaders that are blocking such disclosure, but in the wake of the recent malfeasance within the industry increasing disclosure would be one simple remedy to curb such malicious behavior. Fortunately for many of us, the Rydex family of funds is an open book and has attracted many investors because of its policy of full disclosure. As such, the Rydex family of funds is often used as a proxy for investor behavior. It is also considered by many to be the most accurate sentiment indicator because it represents real investors with real money invested rather than opinion polls from either investors or professionals with nothing to lose. So the funds’ asset size are typically used to measure the state of “bullishness” or “bearishness”.
Typically analysts watch the bull/bear fund ratio which can vary in composition from analyst to analyst. The simplest ratio is the Rydex’s Nova Fund asset size (Bull: +150% SPX) to the Rydex’s Ursa Fund asset size (Bear: -100% SPX) ratio, while the broadest measure includes all 11 of the Rydex’s index based funds (6 bullish and 5 bearish). Even these can be computed in a variety of ways. For example, the ratio could be adjusted by the daily price of the fund each day so that the number of shares owned is compared rather the actual dollar amount of the fund. Then of course you could create separate bull/bear ratios for the NASDAQ and SP500 funds as depicted in Figure 1. The fact remains that the data from the Rydex family of funds is used to get an inside look at where the money is going. If you review figure 1, you’ll see that the NASDAQ 100 index (NDX) fund’s ratio has actually been decreasing while the SP500 fund’s ratio have been increasing. This means that the NDX funds are getting less bullish and the SP500 funds are getting less bearish.
Of course, one could state that the NDX was getting bearish, but with a ratio of 6 bulls for every bear. It would take a radical turn of events to change the bullish nature of the NDX participants. And as for the SP500 investors, well they were decidedly bearish as the ratio had a value that was equal to 0.5. This means that there were 2 bears for every bull. So the SP500 investors were, until recently, quite bearish. As a matter of fact, it was only on the last trading day of the year (12/31/03) that the ratio reached a value of one, which means that the amount of money in the bullish funds now equals the amount of money in the bearish funds. So now there is a bull for every bear. This is quite a change from just 60 days earlier when there were 2 bears for every bull.
However tracking the sentiment of these funds is not the only useful purpose for this data. What if you could see how investors were reacting to price fluctuations? As a matter of fact you can see how investors are behaving by using the same data. This unique presentation of the data was developed to answer a few simple questions. What are investors doing? Do they buy the dips? Do they buy the highs? Are they momentum followers? These questions naturally lead to asking about the quantity of new purchases and how existing shareholders are doing. The next chart presented in figure 2 attempts to answer these questions by plotting the five day total of the new purchases of 11 Rydex funds and the five day gains and losses of the existing shareholders. These are plotted along with the SPX's closing price.
Notice the divergence in December 2003 between the SPX prices and new purchases. Investor's aren't chasing these higher prices. New purchases are slowing down at these higher price levels leaving us to wonder about the future of higher prices. Also notice that as the SPX rose to higher levels, the five day change in value of existing shareholder's didn't rise above the previous rally around Thanksgiving. In this context, investors who have already purchased Rydex funds are profiting from the rise in prices but the gains aren't as strong relative to the gains a few weeks ago.
In figure 2, the cash flow was presented as a five day oscillator and that the power behind the current rally during the holiday week was weakening as prices rose. In figure 3, the cumulative cash flow of the 6 Bullish Rydex funds and the 5 bearish Rydex Funds along with the cumulative change in value of existing shareholders is shown. This was computed by adding the new purchases of today to yesterday's total, etc. This chart shows us that the new purchases of bullish funds in steadily increasing while new purchases of bearish funds is steadily decreasing. Also note that the value of existing shareholders is following the same trends. The bullish funds are yielding profits while bearish funds are losing money.
So in summarizing these two charts it can be said that while the amount of these new bullish purchases is increasing, on a weekly basis, the rate of change is decreasing. In addition, you can see that as the market rises so does the volume of purchases. Interestingly, at no point did the bullish funds new purchases (dark blue line) cross into the negative zone so there hasn't been a net sale (more sellers than buyers) day yet this past month. Apparently Rydex bullish investors don't buy the dips and sell the highs. They are more inclined to buy highs and hold on to their shares at the lows. Also worth noting is that the bear funds are both losing value and investors. The new purchases (red line) of bear funds is negative indicating that there are more investors leaving the fund than buying the fund.
However it can't be determined if those formerly bearish investors are now buying bullish funds. There's not enough data to definitively answer that question. One can only speculate if they are. Of course if the bears are beginning to capitulate and the bulls remain stalwart, then the bears will be forced to buy shares at higher prices due to the fact that the supply of stock is diminishing for the bears (as the bulls fail to sell their shares). This could lead to an old fashion short squeeze rally that will carry prices to the moon. However, this scenario is tempered by the fact that many investors may be waiting to sell their shares in 2004 to avoid paying any taxes on their gains in 2003. This would enable these investors to defer paying taxes on these gains until April 2005, thereby enabling them to use these pre-tax dollars in any number of ways before 2005. Given that most money now in the stock market is from mutual funds, many managers will more than likely opt to lock in gains or at least offset losses with commensurate gains to report performance gains with "rose colored glasses".
Figure 1 – The Rydex bull/bear ratios computed from asset size and from the approximate number of shares owned.
Figure 2 - Rydex funds Bull/Bear 5 day oscillator.
Figure 3 - Rydex Bull/Bear Investor Cumulative cash flow
Part II – Show me the money.
What was hot last quarter? Here's a view of how the Rydex family of funds grew in size last quarter. Please note that this presentation of these funds does not represent how much money you would have made as an investor. This view is to demonstrate where investors are putting their money and shows you the funds that grew the most in size. In figure 4, the top six funds that grew the most in size are plotted. Again, this didn’t mean that they made the most money. For a look at how these funds performed on a price (NAV) basis look at figure 5. Proportionately, the basic materials fund grew the most from $7 Million in assets to $160 Million in assets. Now the question to ask is will the basic materials fund continue to be the "hot fund"? (Please note that in addition to the basic material fund, Rydex has a precious metal fund that didn't make the top six despite the rise in gold and silver prices. See figure 6.)
In figure 5, the prices of the top six growing Rydex funds are shown. As you can see, the NAVs from the funds that grew the most in size didn't appreciate as much in value as compared to their size. Plus, these funds appeared to appreciate in value about the same amount. So let's look at the percent change in value of these funds in figure 7.
Here the percent changes in NAVs of the Rydex funds that grew the most in asset size are presented relative to October 17, 2003. This chart shows you that in relative terms, investors saw prices of these funds appreciate in value by 11% to 15%. This shows us that investors from these 6 funds saw about the same amount of price appreciation. So investing in any of the these funds during the last quarter produced profits, but this chart only shows you how prices appreciated during the last quarter. Now let's look at how much money investors are making in these funds.
In figure 8, the chart displays how much money investors made over the last quarter in each of the top growing funds. As you can see, the SP500 investors (RYNVX, RYTNX) made the most money. Remember this is different from the typical performance view which was shown to be about the same for all six funds –a 14% increase. These investors as a group made $40 Million. This is due to two factors. One, the SP500 funds sizes are substantially larger than the other funds, and two, their were more investors invested in these funds before the December rally in prices appeared. In contrast, notice that the basic materials fund (RYBIX), which saw the largest influx of investors during the same period (figure 4), didn’t see prices rally proportionately higher (figure 5 and 7). This is causing the cumulative profit and loss from those investors to dip down in the basic materials fund because most of the investors bought into the fund after prices rose 10%. Lastly, while it was noted that investors could have made 14% last quarter from virtually all six funds, the amount of money that was made varied substantially between these six funds due to the timing of these investors’ entry into the funds.
In figure 8, you can see that the investors in four of the funds made a total of $5 Million each. This is good news for investors as this translates into the fact that they are all in profits. The problem here is that these funds were the recipients of huge influxes of money. Now you might not think this is problem, because pouring money into a sector is good for prices. After all if the sector is "hot", increasing investor interest will only cause prices to rise. It's simple supply and demand. The more investors buy the stock, the fewer shares are left for other investors and they will be forced to pay more for the remaining shares. Now this all is based on the fact that investors want these stocks and it is assumed that these companies are making money. But as you can see, company fundamentals are irrelevant when investors are "stampeding" a stock. As long as the flow of money keeps pouring in and shares are being purchased at any price, the stock price rises.
But what if these top growing funds were viewed in another context. Prices only rose 14% despite a 300% increase in investor purchases. Now you can see the problem. Next you’d have to ask how much longer will investors continue to pour money into this fund or this sector? Regardless of company fundamentals if the flow of money slows down, the decrease in demand will drag prices down. So the essential question is how much money is left to invest? From the current point of view, investors have already stampeded this fund and these investors probably will not put substantially more money into this fund without prices moving higher. They will need to be rewarded for taking a chance before they commit more money to these funds. But from the viewpoint of how much cash is in the Money Market Fund, there remains a tidy sum of $1.4 Billion (1/2/04) that can be used to make future investments. So Rydex investors still have money to invest with. And if you study figure 2 and 3 you can see that these investors rarely invest more than $100 Million in any one given day. So there’s about 20 days worth of buying left if every investor wanted to be fully invested in the stock market. However realistically if you consider the fact that the Money Market fund cash level has not gone below $1.0 Billion then there’s approximately 8 days of buying rather than 20.
So why didn’t prices rise more? If prices only rose 14% despite a huge increase in demand, then their must be a huge supply of stock that is keeping prices from running higher. This translates into a perverse scenario. If the flow of money stops flowing into these sectors, prices will drop. Again, if prices could only rise 14% amidst a 300% increase in purchases then there was overhead resistance to higher prices, and when this resistance disappears then prices will rise. But these data don’t tell us when this resistance will abate. Another possibility is that the fund manager is building up there cash reserves and not investing the money as it is flowing into the fund. These fund managers are presumably waiting for better prices to so that they can buy more stock for the fund and increase their shareholder’s value. While this remains a possibility, there is no data to support this as cash reserves for mutual funds are at record low levels since the market highs set in 2000. So in conclusion, these funds are at a greater risk to decline than the SP500 funds because these cash flows are more likely to abate before the overhead resistance disappates.
Now the SP500 funds tell a different story. In contrast to the basic materials fund, the Rydex Nova and Titan Funds (RYNVX and RYTNX) only had a 30% to 40% increase in the flow of funds and prices rose 12% to 15%. This is a better ratio than that of the Basic Materials fund and the others (RYBIX, RYEUX, RYEIX, RYVIX). A little investor purchasing created a little price gain. In this case, the overhead resistance or over-supply that was apparent in the smaller funds isn’t preventing prices from rising in the SP500. In addition, these SP500 investors can watch prices drop $40 Million in value before they lose money! Basically, they have more profits than the basic materials group of investors, and so they have more room for prices to go lower before their "break-even" point is reached. So in the SP500 family of funds, investors will be more complacent than the basic materials investors. Of course, these data don't tell us if one group of investors is more likely to actually sell at a loss, which would speed up any decline in prices. But it does tell us that the SP500 investors will be hurt less by a decline in prices than the other four funds or that they at least can withstand a larger price drop before they lose any money. Presently, these SP500 investors are in essence risking the market’s money and not their own money. It’s still “funny money” or paper profits at this juncture. So it appears that the despite the strong influx of dollars into RYEUX, RYBIX, RYEIX, RYVIX these appear to have a greater risk of declining than the RYNVX and RYTNX due to the smaller amount of profits that each of these funds has generated for its participants and the apparent greater resistance for these funds to appreciate in value.
So what else did these data show us. Well, these data showed us that Rydex investors are more likely to invest when prices are rising. These data tell us that Rydex investors are generally momentum investors rather than value investors. The difference is that value investors buy shares when prices are low while momentum investors buy shares as prices are rising. This is confirmed by watching the flow of new purchases in figure 3. There wasn't a large influx into the funds when NAVs dropped. Investors were more apt to buy these funds when they were rising in price. Lastly, these data showed us that investors aren't afraid of the market and have plenty of money to invest. They're pouring money into stocks at record levels and only time will tell how long they can continue this pace of investing.
It’s interesting that most of the information regarding mutual funds presented to investors is in one dimension – price performance. But in this article, mutual fund data was converted to express investor behavior, which told you more than who finished first or second. By combining the price data with asset size data, you can see how bullish or bearish the fund group is and how that sentiment is changing. In addition, by reviewing the amount of money that was made or lost and comparing the relative changes in fund flow, investors can see how much energy, or money, is needed to move a sector, and if that movement is proportionate to the amount of money needed to illicit a change in price. Plus it also gives you an indication of how likely investors are to bail out, or exit, their investments. These facts can influence the future direction of prices and provide investors with new insights and opportunities to maximize and optimize their investment decisions.
Mutual fund investors are trained to chase the best performers because the industry has focused on providing them with “top ten” lists. While these facts are valuable to potential investors they do not guarantee future returns and shield investors from considering the impact of past performance on their potential investment’s future performance. It’s just assumed that if the fund was great last quarter it will be great this quarter. But as this article demonstrates, it is possible to glean these data to extract another dimension of information, which can provide a glimpse as to how investors have behaved. And if you can understand more fully how mutual investors as a group respond to price fluctuations then hopefully you can make smarter investment decisions, and find more profitable opportunities.
Figure 4 – The top 6 growing Rydex Funds by asset size.
Figure 5 – The top 6 growing Rydex funds price history.
Below is a chart of the prices of the Rydex funds shown above. As you can see below, the NAVs from the funds that grew the most is size didn't appreciate as much in value as compared to their size. Plus, these funds appeared to appreciated in value about the same amount. So let's look at the percent change in value of these funds in the next chart.
Figure 6 – The Rydex Precious Metal Fund’s NAV and asset size.
Below is a chart of the Rydex Precious Metal Fund (RYPMX). The two plots show the price of the Gold/Silver mutual fund and the number of shares that investors own. It's interesting to note how these investors behave. They are apparently momemtum traders rather than value investors. A value investor would be buying the dips. This would appear as an increase in the number of shares as the price dropped. However, this isn't the behavior exhibited by these investors. These investors are buying more as the price rises which is telling us that these investors are momentum traders. They are only interested when prices rise. As soon as prices fall, they bail.
Of course, these data can't definitively tell us if the newer investors sold out as prices dropped or if pre-existing investors took profits and exited. If the first case were true then the newer investor had little tolerance for loses and are trigger happy leaving the fund in "strong hands" - bullish. If the second case were true, then pre-existing investors exited with profits and the newer investor are waiting to become profitable - somewhat bearish. They will need higher highs to see their investment become profitable. However, as the chart shows there isn't the same amount of interest and the money isn't flowing into the fund as prices are returning to the previous highs. These newer investors are counting on a higher high.
Figure 7 – The top 6 growing Rydex funds percent change in NAVs.
Below is a chart of the percent changes in NAV of the Rydex funds that grew the most in asset size. This chart shows you that in relative terms, investors saw prices of these funds appreciate in value by 11% to 15%. This shows us that investors from these 6 funds saw about the same amount of price appreciation. So investing in any of the these funds during the last quarter produced profits, but this chart only shows you how prices appreciated during the last quarter. Now let's look at how much money investors are making in these funds.
Figure 8 – The top six growing Rydex funds cumulative profit/loss for the past quarter.
Appendix: For those of you interested in how these figures were computed.
These are the steps used:
created 12/22/03, ©2003 The Small Investors Software Co.