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Fund Flows: Investors Turn on Bond Funds

Long-term flows go negative; muni-bond funds suffer record outflows.

Kevin McDevitt, 01/25/2011

Bond funds fell further out of investor favor in December. There were an estimated $10.6 billion in long-term outflows in December, most of which came from fixed-income offerings. This follows modest $5.1 billion long-term inflows the previous month. This is the first time since May 2010 that long-term flows have been negative. Money market funds also experienced outflows of $2.2 billion, which owed to $7.3 billion leaving taxable vehicles. Tax-free money market funds, on the other hand, collected $5.1 billion.

Redemptions in municipal-bond funds soared to a record $13.4 billion in December, which builds on the previous month's $7.6 billion in outflows. More on this subject follows below, but note that the past two months of combined outflows represent roughly 4.4% of current municipal-bond fund assets.

Although not nearly as cataclysmic, taxable-bond flows also turned negative in December for the first time in more than two years, as funds shed nearly $4.5 billion. This was the first time since November 2008, when the credit crisis was still in full roar, that money left taxable-bond funds. While negative flows are new, the trends within the asset class are not. As we have pointed out in past commentaries, flows into short- and intermediate-term bond funds have been declining since September 2009.

Alternatively, investors seem to be slowly warming to equity funds. U.S. stock funds still shed about $7.6 billion in assets in December, though, marking the eighth consecutive month of outflows (this despite the S&P 500 index's 15.2% return in 2010). But the pace has slowed considerably, especially considering that most of this past month's outflows stemmed from a shift in asset allocation for Vanguard's target-date funds and several fund of funds.

Vanguard announced this past September that it would increase the international equity allocation in these funds to 30% from 20%. That change hit fund flows in December as Vanguard Total Stock Market Index VTSMX showed outflows of roughly $7 billion, while Vanguard Total International Stock Index VGTSX recorded inflows of more than $8 billion.

If these exchanges are stripped out (as they do not reflect new investor contributions or redemptions), then U.S. equity funds would have lost less than $1 billion in December. This would mark the smallest level of outflows during the past eight months. Meanwhile, international stock funds would have taken in a net $2.9 billion--most of which went into emerging-market funds--after subtracting the Total International Stock Index inflows. Even with this adjustment, international stock funds have now enjoyed four consecutive months of inflows.

Taxable Bond
Within the taxable-bond universe, most of the damage in December hit the two largest categories: short-term and intermediate-term funds. Short-term bond funds lost $1.4 billion, while intermediate-bond funds shed more than $8 billion. We estimate that $241 billion PIMCO Total Return PTTDX endured redemptions equal to approximately 3% of total assets. This follows the fund's roughly $2 billion in November outflows. Perhaps some investors are starting to agree with Bill Gross that future bond returns don't look terribly attractive.

Keep in mind, though, the impact of rising interest rates. The yield on the 10-year Treasury has spiked about 100 basis points since early October. Intermediate-term bond funds dropped nearly 0.8% on average in December alone.

Intermediate-term government funds, which tend to be more rate sensitive, got hit even harder and suffered their worst month of redemptions in more than seven years. Investors pulled about $3.1 billion in December, which is the most since $4.5 billion was redeemed in August 2003. Curiously, though, Vanguard GNMA VFIIX and Fidelity GNMA FGMNX saw the greatest outflows last month of more than $800 million and $400 million, respectively. Agency mortgage funds tend to outperform Treasuries in rising-rate environments. Indeed, both funds are in the category's top third over the past three months.

Bank-loan funds are even better equipped for rising rates, though, which helps explain the category's $3.9 billion spike in December inflows. This was the category's biggest haul in its history and is nearly double the previous $2.2 billion high scaled this past April. Performance has certainly contributed to recent interest, as lower-quality bonds have rallied hard since the credit crisis. The category gained 9.3% in 2010, and it fared better than most bond groups after rates began climbing in early October.PAGEBREAK

Fidelity Advisor Floating Rate High Income FFRAX has been one of the primary beneficiaries of this interest, as it took in nearly $800 million in December and more than $3.5 billion for the year. That's about a fifth of the category's total. The fund maintains a relatively conservative credit profile, though, compared with some of its freewheeling peers, which suggests that investors are not blindly chasing performance. The fund actually didn't keep up with most of its rivals in both 2009 and 2010 as lower-quality credits performed best.

That was generally true with other popular taxable-bond categories such as world bond, high yield, multisector bond, and emerging-markets bond as well. These were also the four most popular taxable-bond categories in December after bank loan. Collectively, these five categories took in $95.5 billion in 2010, which isn't that far behind the combined $101.9 billion collected by short- and intermediate-term funds.

This is striking because the short- and intermediate-term categories dominate the taxable-bond universe, with a combined 54% market share and roughly $1 trillion in assets. The other five categories collectively are barely more than half that with $535 billion in total assets. This suggests that investors remain more comfortable taking on credit risk than rate risk these days. Although the pace of flows into world bond and emerging-markets bond funds is slowing, the desire for diversification outside the United States remains solid, too, given the $2.1 billion deposited into world-bond funds in December and nearly $650 million for emerging-markets bond. This trend showed up even within the emerging-markets bond category, as six of the 10 most popular funds in December were those focused on local currency debt.

U.S. and International Stock
Although large-growth and large-value funds remain the most unloved categories within the asset class, large-growth outflows shrank for the fourth consecutive month. That said, the large-growth category has been in net redemptions now for 18 consecutive months, and 27 of the last 30.

On the other hand, small- and mid-cap funds are becoming increasingly popular. This isn't surprising considering that small-cap funds owned the market in 2010, generating category returns in the 25%-27% range. The recent inflows suggest that there may be some performance chasing, given that investors poured a combined $3.5 billion into small- and mid-cap funds in December while pulling $5.3 billion from large-cap funds (not including Vanguard Total Stock Market Index's outflows).

International stock funds had positive flows, but after removing Vanguard Total International's roughly $8 billion in inflows, the bulk of the new December money went into emerging-markets funds.

In fact, emerging-markets equity funds took in a record of $3.8 billion. This has become a very popular category the past two years, as assets have nearly tripled since December 2008 to more than $200 billion. Investors have likely been lured by the category's excellent returns the past two years. These funds gained nearly 74% on average in 2009 and gained an additional 19.3% in 2010, easily outpacing the average large-cap foreign stock fund.

The big beneficiaries this past month were Oppenheimer Developing Markets ODMAX and two DFA offerings: DFA Emerging Markets Value DFEVX and DFA Emerging Markets Core Equity DFCEX. The Oppenheimer fund collected more than $1 billion in December alone, while the two DFA funds welcomed more than $900 million.

Oppenheimer Developing Markets is the largest fund in the category and has more than quadrupled in size to nearly $22 billion in just two years. It got that way in part by turning in a relatively decent showing during 2008's meltdown (although there isn't anything decent about a 48% decline), while fully participating in the rallies in 2009 and 2010.

Muni Funds Experience Worst Ever Outflows
The $13.4 billion that exited municipal bond funds in December shattered the previous record of $8.0 billion set during October 2010. More than $20 billion left municipal-bond funds in the final two months of 2008, which is already significantly greater than the $13.9 billion that left muni funds over four consecutive months of net outflows during the financial crisis starting in September 2008.

Retail investor appetite for munis (or lack thereof) could continue to cause volatility in the municipal-bond market in 2011, particularly as warnings about state and local governments' budgetary challenges reach a wider audience. On Dec. 19, banking analyst Meredith Whitney appeared on "60 Minutes" and predicted the municipal-bond market would experience more than 50 to 100 sizable defaults in the next two years, amounting to hundreds of billions of dollars. Although many bond experts, including PIMCO's Bill Gross, believe this is an exaggeration, the negative headlines alone could continue to cause investors to yank their money out of the muni market, contributing to price declines.

If erratic retail investor appetite does indeed cause more muni price volatility in 2011, faithful muni investors may become less willing to sacrifice stability for the sake of an attractive yield. Some funds increase their income payouts by taking on more credit risk than their peers, but others do so by taking more interest-rate risk by emphasizing long-maturity bonds and using leverage in the form of inverse floating-rate notes (also called tender option bonds).

The latter has long been the strategy employed at Eaton Vance National Municipal Income EANAX, allowing it to beat all of its muni-national long-category rivals in each calendar year from 2003 through 2006. That approach produced a punishing 31% loss in 2008's downturn, though, even as the fund came roaring back in 2009's recovery. Even though many investors stuck with the fund through the financial crisis, many appear to have grown increasingly wary of the fund's volatile profile. The fund experienced over $1 billion in net outflows during 2010, including its largest ever monthly outflows in November ($332 million) and December ($274 million). The fund has also received the second worst thrashing of any muni-bond fund during the latest selloff, losing 9.2% from Nov. 1 through Dec. 31, 2010.

Investors aren't only leaving funds that employ the riskiest strategies, however, which highlights the indiscriminate nature of the selling. Fidelity's municipal-bond funds have consistently produced peer-beating returns with less volatility than the majority of their rivals. Even so, some of the firm's muni funds have experienced sizable outflows in recent months. Fidelity Tax-Free Bond FTABX, which dropped less in value than three fourths of its muni-national long-category peers from Nov. 1 through Dec. 31, saw $306 million in net outflows during these two months, which represents roughly 14% of starting total net assets. The management team's emphasis on monitoring the liquidity of individual holdings means this fund is better equipped to handle large outflows than some rivals.

Miriam Sjoblom, associate director, contributed to this article.  

Kevin McDevitt is a senior mutual fund analyst with Morningstar.

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