Just as the price of stocks in fund's portfolio dictate its value, the trading activity of mutual funds is inherently linked to the price of the stocks in which they invest. When mutual funds buy and sell stocks, the prices of those stocks are automatically affected.
In fact, because of the size of their investments, mutual funds can have a huge impact on stock prices, in both the short and long term. Mutual fund trading can activity push stock prices up or down on any given day, and the herding effect of mutual funds and other large-scale institutional investors can create long-lasting trends that influence a stock's price over time.
The most obvious impact of mutual fund trading on stock prices is the immediate increase or decrease it generates. Since stock prices are the composite result of all the day's investor activity, any huge purchase or sale of an individual stock naturally has a large impact on the day's trading range. If a mutual fund liquidates all its shares of stock ABC, for example, and the trade causes the number of total sales to be higher than the total number of purchases for the day, ABC's price will decrease. The trading activity for that day will show that most investors were bearish, because the majority sold rather than bought the stock. The fact that the mutual fund represents a huge portion of the investors for that day does not matter.
Conversely, if a mutual fund decides to add a stock to its portfolio, the stock price increases in proportion to the size of the fund's investment. An aggressive fund that picks a stock as likely to generate substantial gains may allocate a large portion of its assets to that investment, creating a larger increase than if it had invested in a smaller number of shares.
This effect would be the same if an individual investor bought or sold a large stake in the issuing company, but it is much more common for mutual funds and other institutional investors to wield the kind of buying power necessary to create substantial price changes. Even institutional talk about a given stock can affect its price in the short term.
A less obvious effect of mutual fund trading on stock prices is that of institutional herding. When one mutual fund buys or sells a security, it is highly likely that others will follow suit, if the security in question fits their stated investment goals.
This effect is largely due to a crowd mentality among investors of all experience levels. When one fund manager makes a move, especially a bold one, other managers begin to fear that they have missed out on key information. The fear of loss is generally greater than the desire for reward, so fund managers tend to execute the same trades in the same securities to avoid missing out on whatever lucrative opportunities their competitors are capitalizing on. This effect is called herding, and it serves to exacerbate the impact of mutual fund trading on stock prices by multiplying the number of identical institutional trades happening at the same time.
Because many mutual funds are designed to employ a buy-and-hold investing strategy, they have the power to influence stock prices over the long term. When individuals trade stocks, they tend to push the price up and then bring it back down by selling relatively quickly. The impact of these trades is essentially neutral in the long term. However, since mutual funds can create such large price changes and hold their investments for long periods, they can create long-term bullish trends. In addition, when funds choose a stock to invest in for the long run, they tend to increase their holdings gradually over time. The higher the price goes, the greater the appeal. This consistent increase in mutual fund interest further bolsters the bullish growth of the stock.
In addition, the investment community knows that mutual funds investigate potential trades rigorously, lending additional credibility to fund trading activity. A fund investment indicates that the stock has passed some rigorous vetting processes, while a sale indicates the fund's professional managers no longer have confidence in the issuing company.
If a mutual fund makes a large investment in ABC, for example, the immediate effect is that stock price goes up. However, if the fund holds ABC rather than selling right away, this effect is not neutralized, especially if the fund continues to increase its investment. The increase in ABC's price and the implied fund endorsement signals to other investors that the stock is doing well and maybe gearing up for a bullish run. This encourages both institutional and individual investors to buy the stock, pushing the price up further. Essentially, the immediate and sustained impact of mutual fund investments can create the opportunity for a self-fulfilling bullish trend. Investors think the price will increase, and their subsequent investments, in turn, make that increase a reality.
Conversely, when mutual funds sell off large holdings, the price drop can create uncertainty in the stock market, exacerbated by the fund's vote of no-confidence in the issuing company. Other investors may begin to sell their shares to avoid losses, actualizing the perceived bearish trend.
Like the immediate impact on stock prices of fund trading, the likelihood of long-term trends being generated by mutual fund trades increases if multiple funds or institutions execute identical trades simultaneously.
Using It to Your Advantage
While the impact of mutual fund trading on stock prices can cause bewildering volatility for investors who do not understand the role of institutional investors in the stock market, those who know how to identify this type of activity can use it to turn substantial profits.
For example, if an index removes a given security from its roster, mutual funds or exchange-traded funds (ETFs) that track that index are virtually guaranteed to liquidate their holdings in the immediate future. Shorting these stocks or purchasing put options in preparation for the predictable price drop can be a quick way to generate gains, though it does require a very active and attentive investment style.
Because of the considerable impact mutual funds can have on the stock market, it is important to understand how mutual funds operate and why they choose to execute different trades. A well-rounded understanding of how the stock market works, how and why share prices fluctuate and the role of institutional investors in the determination of stock value will help ensure you make educated choices when building your portfolio.