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By Christine Benz | 10-13-2010 09:44 AM

Fund Flows Show Two Takes on Risk

As some investors move to bonds from stocks to lessen risk, others move up the risk scale to capture higher yields.

Christine Benz: Hi. I'm Christine Benz for Morningstar.com.

When it comes to fund flows, investors appear to be demonstrating a little bit of schizophrenia recently, with some investors gravitating toward bonds and some others looking to risky asset classes.

Here to discuss the latest trends in fund flows is Kevin McDevitt. He is editorial director for Morningstar.

Kevin, thanks so much for being here.

Kevin McDevitt: Thanks for having me.

Benz: So, Kevin, I'd like to discuss the ongoing trend toward bonds. It appears that we're still seeing investors showing a strong preference for bonds over equities. Why do you think that is? What are the drivers there?

McDevitt: Absolutely, there are a couple of drivers. I think the main one is just people are trying reduce risk in their portfolios. And you're seeing it on two fronts. One is getting out of equities, but then there is also a push, I should say, which is not necessarily tied to risk, it's more tied to the lack of return on money market funds.

It's amazing that trends we've seen since the Fed took rates to zero back in December of 2008. Ever since then you saw a huge push into short-term bond funds in particular.

So I think on one hand, again, it's risk aversion in terms of equities, but then even more than that perhaps it's money moving from money-market funds into short-term and intermediate-term bond funds.

Benz: So seeking a little bit of yield pickup. Whether that's a good idea or not, I guess we're not so sure about that, but…

McDevitt: Right.

Benz: …It's the trend we're seeing.

McDevitt: It's certainly understandable, but right, it's a different issue as to whether that's the most prudent use of your assets.

Benz: Right. So, in terms of the risk-averse group, I know that you mentioned to me earlier that you think that the Flash Crash may have been a little bit of an inflection point for some retail investors. Talk about your thoughts there?

McDevitt: Sure. Well, we had that strong rebound, that great rally in 2009, and you had maybe some investors trying to dip their toe back into equity funds. But things really turned on a dime in May. You started to see big outflows again, and I think in part that's due to the Flash Crash.

Again, on that very day, the market was only down about 3%, which in the scheme of things, is not that bad. But for some reason, or I shouldn't say for some reason, I think there was an intellectual or a psychological response to that, where investors felt like there was an issue of market manipulation. And I think there was somewhat of a lack of trust or a loss of trust in the equity markets.

So, I think for some investors after what they've faced in 2008, in the fall of 2008, and then this on top of it, the Flash Crash. I think for a lot of investors that was the last straw, and they said no matter what happens from here on out, I'm never going to get burned that way again.

Benz: So I want to talk about some of the riskier asset classes that you've seen investors embrace. Emerging markets is one, and that is emerging market stock funds and bond funds have seen strong inflows. Can you talk about what you're seeing there?

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