Fri, 14 Dec 2012
Inflows to fixed-income products continued in November on account of market-volatility worries, while equity outflows this year could surpass 2008 levels.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Despite a very strong equity market for the year to date in 2012, investors continue to shovel money into bond funds. Joining me to discuss the latest trends in fund flows is Michael Rawson. He is a fund analyst with Morningstar.
Mike, thank you so much for being here.
Michael Rawson: Christine, thanks for having me.
Benz: The headline here when we look at fund flows, it's a familiar one for the month of November. Outflows from stock funds, big inflows into bond funds. Let's start with the winners. What categories within the bond-fund universe are investors buying?
Rawson: Sure. So, as you mentioned, we've seen this consistent selling out of equity funds and consistent inflows into bond funds. Investors are looking toward intermediate-term bond funds. They are also looking to take a little bit more risk in their bond-fund categories, going into emerging-markets bond-fund categories. The bank-loan [fund category] has also been a winner. High yield has been very successful year to date, even though last month, we did see some profit taking from high yield, so they experienced about $3 billion worth of outflows last month. And it's not surprising because high yield has run up so strongly so far this year.
Benz: Yields are so low on so many of these products, especially sort of those core intermediate-term funds. What's your sense of what investors are thinking in terms of preferring bond funds and what has been a very good year for the equity markets?
Rawson: Well, I think it's that fear. Investors still have this fear of the volatility that's in the markets, and perhaps there is some fear of potential changes in the tax code. So, the stock market has been up, perhaps people are using this as an opportunity to sell stocks now ahead of potential changes in the tax code. And so we actually saw a pretty big flow into money market funds last month, about $73 billion, which was one of the largest flows into money markets for a single month for over a year.
Benz: Are you concerned about some of the flows we've seen into the higher-risk fixed-income categories that investors are maybe barreling in there in search of higher payouts than they can get on the high-quality bonds and bond funds but maybe they're not fully acknowledging the risks?
Rawson: That certainly is a risk that investors aren't fully aware of the role of bonds in their portfolios and how the different bond categories stack up in terms of risk return. We know government bonds traditionally have been the safe anchor portion of your portfolio; for emerging-markets bonds, bank loans, high-yield bonds, those categories tend to be a little bit more correlated to risk in the market. If we were to see a massive sell-off in stocks, those bond categories probably wouldn't hold up as well, and so, investors' portfolios probably aren't going to be as safe as they would have been had they had been fully invested in government-type bonds.
Now, of course, there is the argument that government bonds are now riskier than they had been in the past. Certainly yields are very low, and there is a potential that yields could spike. Also, there is a potential that there could be inflation. So, people have changed their perception about bonds in general.
Benz: It's not that investors have necessarily been forgoing the intermediate-term, higher-quality funds. Let's just quickly run through some of the firms that have been getting assets in that intermediate-term bond space?
Rawson: Sure. Well, PIMCO, of course, has been a big winner. Obviously, PIMCO is a bond shop there. They have a strong stable of bond funds. Another strong fund this year has been DoubleLine Total Return. DoubleLine, obviously, is a newer fund company, but managed by a very experienced bond-fund manager, Jeffrey Gundlach. DoubleLine Total Return has been one of the fastest-growing funds this year.
Benz: Now, let's segue to the U.S.-stock fund universe, not as happy a story, with $14 billion in outflows in the month of November alone and $100 billion for the first 11 months of this year. What do you think is driving investors out of equity funds, and what are the trends that you see in that universe?
Rawson: Well, again I think it's a fear of the equity markets; it's a fear of the volatility that people see in equities. It's been a phenomenon, obviously it started in 2007-08 when the market started to crater, but it's actually picked up over the last three years, these outflows from actively managed stock funds. So, this year could actually surpass the record outflows we saw from stock funds in 2008. We could see even a bigger year this year, and it's quite surprising.
Now, we know that investors are going into bond funds. They are also choosing passive equity funds. So, passive equity funds have seen some inflows, particularly ETFs. But another way to kind of slice the data, something that we've been looking at is if you look at U.S.-stock funds, the funds that have been experiencing the most selling, we did an analysis of the fund characteristics to see which funds are experiencing the worst redemptions. And when you look by fee quintile--so we group mutual funds by expense ratio--we saw that active funds with higher expense ratios have had a faster decline rate, as you would expect.
Benz: That's a rational decision-making thing then too, on the part of investors. They are saying higher costs are not necessarily indicative of a good long-term performance pattern?
Rawson: Absolutely. As Morningstar's Russ Kinnel has studied, if there's anything that is predictive of future returns. It's the expense ratio.
Benz: You also found that some other characteristics contributed to funds being able to hang on to their assets a little better. You looked at the Morningstar Analyst Rating and saw that in fact funds with high Analyst Ratings had done a better job of hanging on to their assets than those that have poor ones. What do you think is going on there?
Rawson: We came out with the Morningstar Analyst Ratings about a year ago. So, we have a year's worth of data, and the Morningstar Analyst Ratings are based on a five-tier system--Gold, Silver, Bronze, Neutral, and Negative ratings. And what we find is that the neutral- and negative-rated funds have had double-digit declines. This is for U.S.-stock active funds.
These Neutral- and Negative-rated funds have had pretty strong declines, whereas Gold, Silver, and Bronze funds have held up a little bit better. And so we think that's not really surprising. I mean this isn't to imply causation, but what we find with the Gold, Silver, and Bronze-rated funds is that those funds tend to have lower expense ratios. They tend to have good risk-adjusted performance track records. They tend to have a strong investment-management process.
Those are the attributes that you'd expect to be associated with stronger funds. Those funds have been more resilient. In fact, a number of those funds have had strong inflows. So, it's not all been outflows. But when you look at the Negative-rated funds and even the Neutral-rated funds, they have seen much stronger outflows.
Benz: You've mainly been talking about actively managed funds here, but investors have shown a pretty good preference for passive products recently. Do you think that's driven by outperformance in passive products recently, or what do you think is driving that general preference for all things passive?
Rawson: Predominantly, I think it's fees. The passive products are just tremendously lower in fees, and with the advent of ETFs, the fee differential between active and the passive fund has gotten even wider where passive funds could be had for less than 10 basis points. Some of our favorite funds, Vanguard Total Stock Market, I think is around 7 or 6 basis points. It's just incredibly cheap, and that fund is going to give you market returns. So, people look at that and say, "Well, on average I'm going to get the sufficient market return, with the market risk, but maybe not the opportunity to outperform."
So, what we see is that the popularity of these passive funds will probably continue. At some point though, it gives opportunities for those active managers, those stock-pickers, to find the true hidden gems in the stock market, the stocks that are being sold en masse by maybe other active managers or passive funds. And so, I think it opens up an opportunity for due diligence in terms of finding the right mutual fund manager.
Benz: Mike, thank you so much for sharing your insights on this important topic. We appreciate you being here.
Rawson: Thank you, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.