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Will Investors Return to Equities in 2013?

Strong equity inflows in early January do not guarantee a return to normalized flows this year.

Greggory Warren, CFA, 02/04/2013

If the recent past is any indication of what the future might bring, we could expect investors to continue their preference for capital preservation this year. But an early look at inflows for the first full week of 2013 paints a slightly different picture, with inflows into equities--comprising U.S. stock, sector stock, and international stock funds--exceeding $22 billion, and flows for taxable and tax-exempt bond funds coming in closer to $6 billion. While we are a bit surprised by the magnitude of the equity inflows, the fact that there were inflows is not too surprising, given the amount of portfolio rebalancing that typically takes place in the first part of any calendar year. We also note that the majority of the flows, especially for U.S. stock and sector stock funds, appear to have been driven by passively managed products--index funds and exchange-traded funds--which basically have become the default option for investors looking to gain equity exposure. Given the investment climate we've seen over the past five years, in which investors have shown a willingness to increase their risk appetites during stable and expanding markets, only to pull back dramatically during broader market declines, we're not convinced that this is the start of a trend.

Outflows From Actively Managed U.S. Stock Funds Surpassed 2008 Levels Last Year
At close to $130 billion, 2012 went down as another record year of outflows from actively managed U.S. stock funds, surpassing the $108 billion that flowed out of these funds during 2008 (according to data provided by Morningstar Direct). The results were less dire when excluding the impact of American Funds, which accounted for one third of the total outflows. That said, outflows are now coming from a much wider array of managers overall, with American Funds accounting for more than 40% of total outflows during both 2010 and 2011. With nearly $15 billion flowing out of actively managed U.S. stock funds during December, the fourth quarter of 2012 became the third-worst quarter for outflows since the middle of 2008 (with the fourth quarter of 2008 and fourth quarter of 2011 at $48 billion and $45 billion, respectively).

It also should be noted that December was the 22nd straight month of outflows from actively managed U.S. stock funds, with the segment seeing positive flows on only 12 occasions during the past five years: February 2008, April 2008, May 2008, August 2008, January 2009, April 2009, May 2009, June 2009, January 2010, April 2010, January 2011, and February 2011. There is some seasonality in the flows, with January and April tending to see larger inflows historically due to portfolio reallocations that commonly take place at the beginning of each calendar year, along with the influx of capital that gets diverted into IRAs during the U.S. tax season. This also probably explains some of the data we've seen so far in January, which has hinted at a strong influx of capital into U.S. stock funds. However, it does look as if flows into passively managed U.S. stock funds are outstripping those for actively managed funds.

Index Funds and ETFs Dedicated to U.S. Stocks Saw Stronger Inflows in 2012
While actively managed U.S. stock funds stayed in net redemption mode last year, index funds and ETFs posted their best annual flows since the financial crisis. The biggest winner on the index side of the business continues to be Vanguard Total Stock Market Index VITSX, which until the end of last year tracked the MSCI U.S. Broad Market Index and accounted for more than half of the $24 billion that flowed into U.S. stock index funds during 2012. While its counterpart in the ETF market--Vanguard Total Stock Market ETF VTI--did a decent job of generating inflows as well last year (picking up more than $2 billion in assets), it continues to trail State Street's SPDR S&P 500, which reeled in more than $20 billion last year, accounting for close to 40% of the capital that flowed into ETFs dedicated to U.S. stocks during 2012. The fund did benefit from an inflow of $16 billion last month; moves like this are not uncommon for the ETF as traders tend to use the fund to rapidly place market bets.

Even with these stronger flows, State Street STT and BlackRock BLK continue to cede market share to Vanguard, which has been the fastest-growing provider of ETFs over the past five years--increasing from $42 billion in total assets under management at the end of 2007 to $246 billion at the end of 2012. Vanguard's organic growth rate of 31% last year was not only meaningfully higher than the industry growth rate of 18%, but well above the organic growth rate recorded by its two largest competitors, BlackRock (with iShares posting 14% organic growth last year) and State Street (which posted a 15% rate of organic growth for its SPDR franchise). With an organic compound annual growth rate of more than 29% over the past five years, Vanguard has also had one of the highest organic growth rates in the ETF industry, which has grown at just over 12% per year during the same time frame, with BlackRock and State Street both reporting high-single-digit growth rates with their operations.

Actively Managed International Stock Fund Flows Remain Weak
Even after excluding the impact of net redemptions at American Funds, flows for actively managed international stock funds remained in negative territory during the latter half of 2012. Adjusted flows for the full year looked much better, though, with the more than $12 billion that flowed into the category during April accounting for the lion's share of the $13 billion in inflows that were recorded last year. However, with American Funds reporting close to $18 billion in outflows from its actively managed international stock funds during 2012 (similar to what it saw flow out during 2011), the category remained in net redemption mode. American Funds Capital World Growth & Income continues to have the largest negative impact on flows, with the fund losing close to $8 billion to investor outflows last year after losing more than $9 billion to net redemptions during 2011. While the flow picture remains muddled on the actively managed side of the business, it is much clearer for index funds and ETFs dedicated to international stocks, which picked up $25 billion and $46 billion, respectively, in investor inflows last year. While index flows have been relatively stable, picking up $25 billion on average during each of the past three years, ETF flows actually accelerated last year, with 2012 going down as a record year for inflows (with flows being close to double the $27 billion annual run rate that was seen during the previous five years).

Flows Into Taxable Bond Funds Did Not Break the 2009 Record
Much as we had anticipated, flows into taxable bond funds tapered off enough during November and December to keep 2012 from beating the record level of inflows that was recorded for the category during 2009. Flows into actively managed taxable bond funds of around $239 billion were about $17 billion shy of 2009 levels, while index fund inflows were about $9 billion lower than they were four years ago. Flows into taxable bond ETFs, though, were much stronger last year, with the more than $48 billion that flowed into the category not only $10 billion higher than 2009 levels but $5 billion higher than the record inflows of $43 billion in 2011. Although 2012 was not a record year for taxable bond inflows, the fact that more than $314 billion flowed into the category last year continues to astound us, given that taxable bond yields remain at extremely low levels and the stock market (as exemplified by the S&P 500 TR Index) was up 16% during 2012. Add flows into tax-exempt fixed-income funds, and total inflows for bond funds overall were $368 billion last year (below the record level of $406 billion that flowed in during 2009), which compares with just over $45 billion in inflows for equities--U.S., sector, and international stock funds combined--during 2012, which is on par with 2009 results. At this point of the cycle, it looks to us as if investors continue to be lured more by the notion of capital preservation than the potential for capital appreciation.

BlackRock Recaptures ETF Flow Title From Vanguard
Flows into exchange-traded funds reached a record level of $191 billion in 2012, surpassing the previous record of $161 billion during 2008. Unlike that year (which was dominated by flows into ETFs dedicated to U.S. stocks), flows during 2012 were more widely spread out among U.S. stock, sector stock, international stock, and taxable bond ETFs. At more than $1.3 trillion, ETFs accounted for 13% of total industry assets under management (excluding the contribution from money market funds) at the end of last year, with the category more than doubling in size over the past five years. While Vanguard has garnered most of the ETF inflows the past couple of years, in 2012 BlackRock's iShares division posted its strongest inflows since 2009. The $61 billion that iShares pulled in during 2012 accounted for one third of total ETF inflows, putting it more on par with the slice of the pie that Vanguard has been helping itself to for the past three years.

We have to wonder how much of the increase in flows for iShares is tied to actions BlackRock is undertaking as opposed to the firm benefiting from changes that have taken place at Vanguard. At the beginning of the fourth quarter, Vanguard announced it would be switching 22 of its biggest index funds (and their corresponding ETFs) away from benchmarks provided by MSCI as part of its ongoing effort to reduce costs for investors. While the immediate response to this announcement was a falling off of monthly ETF flows from what had been a monthly run rate of close to $5 billion to something closer to $3 billion during October and November, it looks as if flows returned to more normalized levels during December. Having believed that Vanguard's index provider swap would end up costing the firm some of its institutional business, given that many institutional investors are wedded to the MSCI benchmarks for their international investing mandates, this only explains part of the reason iShares saw a marked improvement in flows in the last few months of 2012. We think the rest of it has to do with BlackRock's decision in mid-October to cut fees on six of its larger, more liquid core asset class ETFs, which is where iShares has been hit the hardest by Vanguard's ETF offerings, and to offer four new long-term ETFs with lower fees to combat fee competition. While these 10 ETFs accounted for more than 25% of the firm's total net inflows during the fourth quarter, we also note that iShares generated inflows in excess of $1 billion last year with 20 different products, which speaks to the breadth of BlackRock's ETF operations.

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Greggory Warren, CFA, is a senior stock analyst with Morningstar.
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