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Great expectations for an investment rotation

After years of sticking with plain-vanilla bond mutual funds, investors are starting to turn their backs on them and opt for stock funds instead.

After years of sticking with plain-vanilla bond mutual funds, investors are starting to turn their backs on them and opt for stock funds instead.

The move isn't big enough to be the "great rotation" many predicted - it's more of a good rotation - but fund managers say more is on the way.

Investors plugged $198 billion into stock mutual funds through the first 11 months of the year. That's the most since the dot-com stock bubble in 2000, according to Morningstar. Bond mutual funds are also taking in money, but the dollars are increasingly going only to niche corners of the market.

Investors pulled $73 billion out of the largest category of bond mutual funds, intermediate-term bond funds, over that time. That marks a stark shift in behavior: Since the 2008 financial crisis, investors have largely sought the safety of bonds and shunned stocks.

Heading into this year, many strategists expected a move into stocks en masse. Bonds had served investors well for three decades, but interest rates had fallen sharply. Stocks, meanwhile, have the potential to offer bigger returns.

But there was no early-year rotation, as investors were comfortable adding money to both stock and bond mutual funds.

"Then a switch went off in May," said Michael Rawson, a fund analyst at Morningstar. That's when worries about rising interest rates began to spike, which hurt bond prices. Investors have since increasingly shown their preference for stocks over traditional types of bond funds. Consider that:

In June alone, investors pulled $16 billion out of municipal-bond mutual funds, according to Morningstar. Through November, investors have yanked a net total of $49 billion this year.

Net investment in stock mutual funds and exchange-traded funds this year will likely top that of the four prior years combined, according to Strategic Insight, which tracks the mutual-fund industry.

In a sign of how the tide has turned, Vanguard last week closed one of its stock mutual funds to most new accounts and reopened two of its bond funds. Funds typically close to new investors when they're attracting lots of money and want to keep from getting too big and unwieldy. They reopen when they want to attract more dollars.

A major driver for the shift is fear that rising interest rates will hurt bond funds. When rates rise, prices for existing bonds fall because their yields suddenly look less attractive. Such worries flared as the yield on the 10-year Treasury note nearly doubled from 1.6 percent at the start of May to roughly 3 percent in September.

Stocks, meanwhile, have climbed worldwide amid rising corporate earnings, stimulus from the Federal Reserve, and hope that economies from Europe to Japan are improving. The Standard & Poor's 500 index set a record high last week.

To be sure, most investors will always have some interest in bonds. They tend to be less volatile than stocks, and the need for income investments will rise as more baby boomers retire. Pension funds and institutional investors also need the steadiness bonds provide.

"You need to have that anchor to lower volatility," said Avi Nachmany, director of research at Strategic Insight.

Investors used to flip between investments quickly and opportunistically, Nachmany said. But now, they increasingly stick to a plan and keep a certain percentage of their portfolios in stocks and a certain percentage in bonds. Target-date retirement mutual funds have grown in popularity, for example, and they always keep a portion of their investments in bonds.

Investors who have made the move from bonds to stocks have set themselves up well, if Wall Street strategists are to be believed.

Most investment banks are forecasting continued gains for stocks in 2014, though more modest than this year's 24.5 percent surge. This year is on track to be the best for the S&P 500 in at least a decade.

Investment banks also are calling for continued struggles for bonds.

"Investors have begun to see the potential for stocks after 10 to 12 years of getting not much return, vs. high-quality bonds," said John Manley, chief equity strategist at Wells Fargo Funds Management. "I think it's just the beginning" of the rotation into stocks from bonds.