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By Christine Benz | 03-26-2012 03:00 PM

Hitting the 3 Sweet Spots of the Market

Technology, financials, and consumer cyclicals all fared well during the first quarter as investors took on more risk, boosting the performance of funds well-positioned for those sectors, according to Morningstar's Shannon Zimmerman.

Christine Benz: Hi. I'm Christine Benz for Morningstar. Mutual funds posted exceptionally strong gains during the first quarter as investors embraced risk-taking. Joining me to discuss some of the latest trends in the fund world is Shannon Zimmerman. He is associate director of fund analysis for Morningstar.

Shannon, thank you so much for joining me.

Shannon Zimmerman: Thank you for having me, Christine.

Benz: Shannon, on the top of your list of things you'd like to talk about are some of the trends we've been seeing in mutual fund inflows and outflows. It's been pretty interesting to watch investors gravitate to bonds.

Zimmerman: Absolutely.

Benz: Has that continued to go on?

Zimmerman: It has. We don't have the data yet for March. But I think that the trends that we've seen so far on the year-to-date period will probably persist, and yes, people can't stop stuffing money into taxable bond funds especially. What you said is exactly right. This year has been a strong year for domestic equities. The S&P 500 is up about 12%, and so is the Russell 2000. So you have these broad market indexes for the large-cap and small-cap sectors doing quite well. But that's not where the fund flows are going, at least in terms of mutual fund flows.

Benz: Is it just that the financial crisis was such a searing experience that people really don't care about the upside as much as they care about not losing again?

Zimmerman: You have to imagine that that's a part of it, right? It's a shell shock still to this day. You look at the fund flows going in torrential amounts into taxable bonds, but the returns that folks are getting there are quite tepid. I think that for the year-to-date period, the typical taxable bond fund is up around 2%, and yet that's where the lion's share of assets have been flowing into. For better or worse, usually we preach against performance-chasing, and in this situation it might be wise to heed that given how low bond yields are right now. How much more upside is there if you focus on total return for the average bond fund? It might be that equities are looking more attractively valued relative to bonds now.

Benz: I know you keep track of what's going on with equity fund flows. You noted that the flows out of equity funds at least have moderated a little bit.

Zimmerman: That's right. The pace of outflows has slackened. You and I were talking before this segment that if you add in exchange-traded funds, it looks even more attractive for domestic equity funds. So as soon as I get back to my desk, I'm going to do a little research on that one.

Benz: So, once you add back in the flows that we've seen into some of the equity ETFs, it's maybe even a better picture for domestic equity funds?

Zimmerman: Exactly.

Benz: Let's talk about some of the big winners in the mutual fund world so far. Technology has been a big winner and certainly the sector funds there. Financial-services funds have been winners, as well. What's driving that?

Zimmerman: You said earlier that the investor appetite for risk is back, and that seems to be a part of it, too. Obviously we should qualify this. It's a year-to-date period, a very, very short period of time. Things thing can turn on a dime. The last time we got together, we talked about how January and February activity had looked quite different. What did well in January didn't do so well in February, but with those qualifications out of the way, on a year-to-date basis the three sweet spots of the market are the technology, financials, and consumer cyclical sectors. They have been the ones that have fared the best and so that is sort of a profile in courage in terms of investors cottoning to risk again.

Benz: How about the Morningstar Style Box view when you look at large-cap funds versus small caps or value versus growth? What kind of performance trends do you see there?

Zimmerman: Well the interesting thing there is that its a rare sighting of growth outpacing value during the past decade. I think that has to do with the particular period of time that you look at as the measurement period. People got stung by two bear markets in the last decade, and some of the same trends that we're seeing in terms of fund flows into bond funds rather than equity funds is a dynamic that's in play there too. People have become more cautious and justifiably so. But during the first quarter anyway, growth funds have outpaced value funds, and that doesn't happen too often.

Benz: Did this risk-on appetite extend to international-focused funds, as well?

Zimmerman: It did in terms of investor flows. In terms of our international categories, flows into international funds have been positive. They are much better than what we have seen on the domestic-equity side.

Benz: In emerging markets in particular, right?

Zimmerman: Exactly, people still have an appetite for that kind of risk as well, and to the significant extent that foreign funds are outperforming in terms of flows into domestic-equity funds, it's driven in large part by interest in emerging markets. It's sort of a schizophrenic investor profile right now because you have all this money going into bond funds and then when you look at the areas of mutual fund world on the equity side, it's emerging markets that are doing the best. So, it's risk-on, risk-off even within the typical investors' own patterns right now.

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