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Fund Flows Paint a Contradictory Picture

Investors seem to be avoiding risk in most areas except emerging markets.

Kevin McDevitt, 08/24/2010

Flows into U.S. open-end funds increased slightly in July to $14.1 billion versus $13.5 billion in June. But this small change understated the acceleration in this year's underlying themes. Almost universally, outflows picked up in equity and balanced categories; and inflows rose for bond, alternative, and commodity funds.

Nearly $12.4 billion exited U.S. equity funds last month, despite a strong rebound in share prices. While the average domestic large-blend fund is still down 6.8% overall during the past three months, the category gained 6.8% in July. International-stock funds saw less severe outflows of $565 million, but strong flows to emerging markets offset redemptions from foreign large-blend funds.

Interest in bonds continued to pick up steam, with taxable-bond funds adding $22.3 billion in July. This is a 26.7% gain over June's rate. Results for municipal-bond funds were even more dramatic, with inflows nearly doubling month over month to $3.9 billion.

These trends suggest that risk aversion continues to be the dominant sentiment, but that makes the continued flows out of relatively conservative balanced funds all the more confounding. The moderate-allocation category took the brunt of this development with nearly $2.1 billion in outflows.

On the other hand, alternative and commodity funds continued their surge. Alternative funds took in about $1.7 billion, with the long-short and bear-market categories benefiting most. The bear-market category has amassed $3.2 billion over the past year, despite losses of 24.9% during that time.

(View the related graphic here.)

Embracing Emerging Markets
In looking at the international-stock flows, there's less evidence of this risk aversion, at least as it's traditionally defined. Most of the recent inflows here have targeted diversified emerging-markets equity funds rather than the broader foreign-stock categories (foreign large value, blend, and growth). In July, diversified emerging-markets stock funds took in almost $2 billion, while the three major foreign-stock categories saw combined outflows of $624 million.

This isn't a recent trend, either. During the past 12 months, diversified emerging-markets equity funds have absorbed nearly $20 billion versus $25 billion for diversified foreign-stock offerings. While foreign-stock funds have the edge during that period, it's actually a fairly small margin, considering that those three foreign categories combined have nearly 4 times the assets of the diversified emerging-markets category.

What isn't clear is how much of this move to emerging markets is a strategic shift or just performance-chasing by investors. After all, emerging-markets stock funds have smoked most competitors over the last decade. The typical fund has delivered 10.6% annualized over the last 10 years versus a loss of 1.3% for the S&P 500 Index.

The broader emerging-markets story is now familiar to most investors. New phrases and acronyms such as BRICs, decoupling, and the "new normal" have been at the center of the discussion for at least three years. Many investors now take it for granted that emerging markets will deliver superior growth to the industrialized countries. Because of their often lower debt/gross domestic product ratios, investors may even see emerging markets as safe havens from industrialized countries' indebtedness. With these factors in mind, then, investors may be making strategic reallocations to emerging markets.

If so, that's a stunning reversal in investor attitudes. A decade ago, on the heels of the S&P 500's dominance, many individual investors questioned the wisdom of investing abroad at all, much less in emerging markets. Those views were reinforced by the Asian crisis and the Russian default in 1998. That year the average emerging-markets equity fund lost 26.3%; assets stood at less than $14 billion for the entire category.

Compare that with $159 billion in total assets today, up nearly 41% over the past 12 months alone. This rush of popularity comes despite the category's average 54.4% loss in 2008 during the financial crisis, which was far worse than the S&P 500's 37% drop.

The same trends can be seen with emerging-markets bond funds, but the numbers are smaller. After taking in more than $1.2 billion in new cash in July, emerging-markets bond-fund assets have more than doubled to $30 billion over the last year. Again, this is perhaps not that surprising given the group's great returns and typically higher yields. Emerging-markets bond funds have actually had an even better decade than their equity cousins, delivering annualized gains of 11.2% over that time.

What is noteworthy, though, are the relatively large flows into local-currency emerging-markets bond funds. Historically, most emerging-markets bond funds invested almost entirely in dollar-denominated government sovereign bonds. Most fund managers have typically avoided local currency bonds. However, as credit quality has improved, U.S.-based managers have been increasingly willing to buy sovereigns (and even some quasi-sovereign and corporate bonds) in local currencies.

Perhaps out of a desire for dollar diversification, U.S.-based investors have been joining in, too. PIMCO Emerging Local Bond PLBDX received nearly $3.6 billion over the past year. That dwarfs the $400 million collected by its older hard-currency sibling, Emerging Markets Bond PEMDX. Short-duration, local-currency sibling Developing Local Markets PLMDX has also taken in lots of cash--nearly $2 billion during the past year. Partly as a result of these recent inflows, Emerging Local Bond and Developing Local Markets are now the categories' two largest offerings.PAGEBREAK

And this trend is not limited to PIMCO, either. Both Goldman Sachs Local Emerging Markets Debt GAMDX and Dreyfus Emerging Market Debt Local Currency DDBAX land in the category's top 10 for one-year inflows. Goldman Sachs Local Emerging Markets has attracted nearly $1.2 billion during that time. That's astonishing growth, considering that the fund opened its door just 2.5 years ago in February 2008. Indeed, this subcategory of funds hardly existed just four years ago.

(View the related graphic here.)

Vanguard and PIMCO continue to be the big winners as investors flood into bond funds. PIMCO took in $5.9 billion in July, while Vanguard added $4.6 billion. PIMCO Total Return PTTDX dominated inflows with $2 billion, though its monthly take continues to taper off.

Sibling PIMCO Unconstrained Bond Fund PUBDX continues to enjoy strong momentum with a $615 million inflow. Its popularity mirrors that of the multisector-bond category overall. The fund launched just over two years ago in June 2008. It has been a hit with investors, even though its performance has been disappointing so far. It finished near the bottom of the category in 2009 and is close to the bottom decile again this year. But the fund's absolute-return focus and disregard for benchmark weightings may appeal to those who became disenchanted with traditional asset allocation following the financial crisis.

This desire for more unconventional, go-anywhere, absolute-return options also shows in the strong flows to world-allocation fund BlackRock Global Allocation MDLOX and world-bond offering Eaton Vance Global Macro Absolute Return EAGMX.

Alternatively, American Funds continues to suffer tremendous outflows, as it watched another $4.6 billion walk out the door in July. The story for American has been the same for almost two years now. For their part, the firm continues to stick to its knitting, maintaining its fairly conventional fund lineup. Plus, the outflows have come despite many American's funds having fared well in recent years and still carry excellent long-term records.

Meanwhile, Vanguard has had the opposite experience. Not surprisingly, its bond funds have enjoyed excellent inflows. But even its equity funds have fared well, especially its passive offerings. Bucking the trend among its domestic-equity peers, Vanguard Total Stock Market Index VTSMX absorbed $1.3 billion in new money in July. The same trend shows up among international-stock funds, in which nearly $700 million was added to passively managed funds, while more than $1.2 billion was withdrawn from their actively managed peers.

Is there a paradox at work? On the one hand, investors seem to be reducing manager risk at the security selection level by adding to passively managed equity funds, rather than their actively managed rivals. On the other hand, go-anywhere offerings in categories such as world-allocation and multisector bond have been very popular. This suggests that investors are more comfortable letting managers set their asset allocation but not choose their securities. It will be interesting to see whether this apparent contradiction holds. 

Kevin McDevitt is a senior mutual fund analyst with Morningstar.

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