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Funds Flows: More Equity Outflows in August

Investors go bonkers for bond funds.

Kevin McDevitt, 09/17/2010

Long-term open-end fund flows increased by more than 11% in August, and once again the lion's share went to fixed-income funds. Taxable-bond funds attracted $24.6 billion in new money for the month, and municipal-bond funds absorbed another $5.2 billion. Taxable-bond funds have now taken in $168.4 billion for the year to date. Alternative strategies also took in a robust $3.1 billion in August.

Intermediate-term bond funds dominated once again, taking in nearly $18.5 billion for the month. Diversification, though, remains a priority for investors, as multisector bond and world bond funds came in second and third, with $3.0 billion and $2.7 billion, respectively, in flows. Emerging-markets bond funds remain popular, too, with $1.1 billion in inflows. Category assets have now reached $32 billion versus $15 billion 12 months ago.

On the other hand, even though the long-government and long-term bond categories have enjoyed strong returns, inflows remain modest. These two categories absorbed just $191 million and $157 million last month, respectively. That's despite the long-government category gaining 8.4% in August alone and 25.2% for the year to date.

Meanwhile, the relentless outflows continued for U.S. stock funds, as another $14.3 billion headed for the exits. This continues the renewed aversion to domestic-equity funds that began with May's flash crash. During the past four months alone, these funds have shed a combined $48.9 billion.

Large-growth and large-value funds are taking the brunt of investor discontent. These two categories surrendered nearly $9.1 billion in August alone and a combined $35.6 billion for the year to date. That latter figure represents nearly three fourths of all U.S. equity outflows. Curiously, large-blend funds have escaped relatively unscathed. They have lost just $309 million to outflows so far in 2010. This owes to the fact that the most popular index funds (that is, those that track the S&P 500 and total market indexes) call the large-blend category home. Conversely, index funds make up a far smaller proportion of assets in the large-growth and large-value categories. In keeping with continued investor preference for passively managed funds, this group welcomed $12.5 billion in August flows, which almost offset the nearly $12.6 billion that left their actively managed, large-blend counterparts.

After enduring mostly outflows since early 2009, money market funds took in $11.8 billion in August. This is on top of the $4.9 billion in inflows the previous month. Embedded within the monthly total are even stronger flows for taxable money market funds. That group collected more than $18.5 billion during the month, while tax-free funds saw $6.7 billion in outflows. As for this renewed interest in money market funds, this may be another residual effect of the greater risk-aversion stemming from May's flash crash; more on this topic follows below.

Keep Redemptions in Perspective
It has certainly been a rough couple of years for U.S. equity funds. Since the meltdown in 2008, money has continued to leave in droves. Nearly $40 billion has already walked out the door so far in 2010, after $25 billion left in 2009.

However, this doesn't add up to mass capitulation. To put things in perspective, even as the bear market's three-year anniversary approaches, domestic equity funds still account for more than $2.9 trillion in assets. The combined $68 billion in outflows since the end of 2008 is not even 2.4% of that total.

The S&P 500 Index is still down 28% (as of Aug. 31, 2010) from its high in October 2007. Assets in U.S. stock funds peaked at nearly $4.1 trillion during that same month. Naturally, total net assets in these funds have fallen along with the market. Declining equity prices explain far more of the drop in U.S. equity-fund assets, though, than do outflows.

Shift in Investor Sentiment
That said, there has been a marked shift in investor sentiment since the May 6 flash crash. Although domestic equity funds registered outflows in the last four months of 2009, investors actually returned a modest $6.9 billion to these funds during the first four months of 2010.

That momentum ended with the chaos and confusion created by the flash crash. Although the S&P 500 Index fell a hardly catastrophic 3.2% on that day, the random and arbitrary nature of the market's violent intraday swings seem to have been the last straw for some investors. About $15 billion was pulled in May alone, and an additional $32.9 billion has been withdrawn in the three months since then. That $48.9 billion represents the worst consecutive stretch of monthly outflows since investors yanked $68.8 billion during the last four months of 2008.

Passively managed funds are an exception to this trend, however. This subgroup within domestic-equity funds has actually enjoyed inflows in 34 of the past 36 months. In fact, that subgroup took in $11.2 billion during the fourth quarter of 2008 when the S&P 500 Index lost 22%. While some of this steadiness owes to buying from defined contribution plans and institutional investors, the inflows have been quite consistent across distribution channels during the past three years. Passively managed funds now control 20% of all domestic-equity fund assets. This is up from 15% in 2000 and 18% a year ago. At least among U.S. equities, investor aversion to manager risk seems to be growing.

Are U.S. Equity Outflows Going Into Bond Funds?
U.S. equity fund outflows are likely contributing to the stratospheric growth in taxable-bond assets, but they aren't doing the heavy lifting. The $42.2 billion in year-to-date U.S. equity outflows are dwarfed by the $168.5 billion that taxable bonds have absorbed so far in 2010. As we have noted in the past, the vast majority of taxable-bond inflows had likely been coming from money market funds (with the past two months as exception). Low yields on money market funds have clearly been pushing investors into bond funds.

What's interesting, though, is how dramatically flows shifted after the Fed decided to take rates to near zero in December 2008. (See image below.) As markets imploded that winter, investors rushed into the safety of government-guaranteed money market funds. From October 2008-January 2009, money market funds absorbed a staggering $470 billion, and total net assets reached about $3.6 trillion--42.6% of all mutual fund assets.

However, it didn't take long for investors to reverse course as yields fell. Beginning in February 2009, investors started reallocating, and money has now left money market funds in 16 of the past 19 months. Investors withdrew about $1 trillion during that time, taking money market total net assets and market share down to $2.7 trillion and 28.7%, respectively. Taxable-bond funds, on the other hand, saw flows turn positive in December 2008 after having suffered outflows during the credit crisis in October and November. Taxable-bond funds have now enjoyed 21 consecutive months of inflows, with $284 billion in net 2009 inflows and $168.4 billion so far in 2010.

Excluding money market flows, PIMCO continues to be the big winner, thanks to its bond lineup. It collected more than $7.7 billion in August, thanks again to PIMCO Total Return's PTTAX robust $5.2 billion haul. Siblings PIMCO Fundamental Advantage Total Return PTFAX and PIMCO Unconstrained Bond PUBAX took in about $1 billion each. These three funds encapsulate investors' tastes these days, with Total Return representing the ongoing thirst for core intermediate bonds, while long-short Fundamental Advantage Total Return reflects the growing interest in alternative strategies. Multisector offering Unconstrained Bond shows the ongoing desire for diversification, but also reflects the freer hand that is being given to managers to move across sectors and asset classes.

Vanguard took the fund family silver medal again this month, although inflows fell to $4.0 billion from $4.9 billion in July. Total Stock Market VTSMX and Total Bond Market VBMFX continued to be the most popular offerings.

On the other end of the spectrum, American Funds continued to bleed money, with nearly $5.5 billion walking out the door. Given that all of its equity funds are actively managed, this family is very much out of step with investor preferences at the moment. Growth Fund of America AGTHX absorbed the worst hit, seeing $1.6 billion in outflows. Its performance is only slightly below average over the past year, but it lands in the currently reviled large-growth category. Fidelity continues to suffer for similar reasons, with its large stable of actively managed equity funds. The firm had nearly $1.6 billion in outflows for the month.

Kevin McDevitt is a senior mutual fund analyst with Morningstar.

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