More Fund Investors Pick Passive Products

McDevitt: No. I think the ones who are really nervous here in this situation are the active managers on the U.S. stock fund side. That's really the group that's being hurt the most and that's seeing the brunt of the outflows. But right, if you look at it more from an asset class overall standpoint, it really hasn't been that severe.

As you said, though, that doesn't take away from the tremendous inflows into taxable-bond funds, municipal bond funds, but the real loser there has been money market funds. Money market funds had outflows of about $32 billion, I believe, in June, and they've seen roughly about $1 trillion or so leave over the last five or so years, and most of that has gone into taxable and municipal bond funds.

Benz: So, I guess it's hard to say what investors in general are thinking there. I'm sure there are lots of different motivations for leaving the money funds, but what do you think are the top rationales investors have been dumping that particular type of asset?

McDevitt: By far it's been the Fed's zero-rate policy. Really you can see a very straight line or a very straight correlation between when the Fed took rates to zero in December 2008, the next month you saw outflows out of money market funds, and ... there have been a few positive months for money market funds, but in general, you've seen outflows, and you've seen very, very strong inflows into taxable-bond funds.

Of course on the muni side, you did have outflows ... not so much this year, they have certainly had a big rebound ... but in late 2009, early 2010, that's when you saw money flowing out of municipal bond funds. But that market has really recovered, too. You've seen strong inflows over the past 12 months or so back into muni funds.

Benz: You mentioned, Kevin, in your report that the high-yield muni category has been an area of special interest for investors. They've really been adding to that group. Let's talk about how they have performed, and also whether you think it's just performance-driven or what are investors responding to there by adding so heavily to that category?

McDevitt: It really fits a broader theme across bond funds: Investors seem to be more comfortable taking on risk in bond funds. I think, unfortunately, it's a product of reaching for yield, but also from seeing pretty strong returns in areas like emerging-market bond funds, high-yield bond funds on the taxable side. But now, on the muni side too, high-yield muni funds.

And part of it is returns. Just year-to-date, high-yield muni funds have had positive returns of about 8%, so that's certainly a driver, but then again I think investors look at the higher yields they can get through high-yield taxable funds, but also high-yield munis now, and high-yield munis actually had the greatest inflows of any muni category for the quarter, and they are number two for the year-to-date, only behind intermediate-term municipal bond funds.

Benz: It's sort of a niche category, right? It's not a huge category to begin with, so that growth in assets is pretty stunning.

McDevitt: It is striking. Then you think of the headline risk as well. You've had the recent bankruptcies of Stockton, Calif., San Bernardino. And you can argue those are isolated incidents, and I think a lot of muni managers anticipated those bankruptcies. So, it wasn't a big shock necessarily. But the systematic issues tied to things like public employees, their retiree costs, the pension costs, the health-care costs--those are fairly systematic, and they apply across the country. So, it's not like the drivers are necessarily going away. But yet, you're still seeing very strong interest in those funds, and plus then you have just falling interest rates generally, or falling yields. So, as yields fall, it's harder for these bond funds to reproduce the returns they've gotten in the past. Your upside is more limited going forward, but the downside is potentially bigger.

Benz: I guess one countervailing force, one might say, is that if people are concerned about higher taxes down the line, and there is this new Medicare surtax that's going into effect in 2013, that makes muni-bond income that much more attractive as a tax-free income source, and there are a very few of those.

McDevitt: That's a great point, and also in that regard, you really empathize with investors. ... If you're looking for ways to create tax-exempt income or just looking for income of any kind, it's hard to come by without taking on a certain amount of risk.

Benz: Absolutely.

Now, Kevin you have also highlighted this strong appetite for all things emerging markets, despite relatively tepid performance. Let's talk about the growth that you've seen in the emerging-markets stock and bond categories?

McDevitt: If you combine those two categories for the quarter-to-date, they had about $11.5 billion worth of inflows, again that's combining diversified emerging-markets stock funds and emerging-market bond funds. Those combined flows are greater than any other category, including intermediate-term taxable bond.

Again, this interest in emerging markets is really this ongoing longer-term theme, but shorter term you start to wonder if investors are at all getting disappointed with the performance. Diversified emerging-market stock funds are down, they're down at least for the quarter, about 8.2%, and over the last three years, you would have done better in a world stock fund than you would have in diversified emerging-markets equity funds. Even though returns have been positive in both cases, you've seen tremendous outflows out of world stock funds, but yet very strong inflows into diversified emerging-market funds.

Then with emerging-market bonds, again a lot of investors are looking for diversification away from the dollar--that is if they are going into local currency funds--or just looking for a source of yield. But, again, those funds had relatively flat returns for the quarter, but that didn't impact inflows in any way.

Benz: Kevin, I would also like to touch on some of the fund family winners and losers. You touched on the growth that we've seen in ETFs, but there's also been a growth in passively managed products, generally. Which fund firms are the biggest beneficiaries of that trend?

McDevitt: Of course, as you might imagine, Vanguard is the clear winner here, but then there are some just purely on the ETF side. You have State Street and the iShares families that both--if you combine, again, open-end flows and ETF flows--both State Street and iShares would be in the top five along with Vanguard and PIMCO.

So, really you're seeing the interest in passively managed funds goes across open-end firms and ETF firms. And what really strikes me is just looking at the growth of market share for passively managed vehicles of all kinds. Ten years ago, passively managed funds had overall market share of about 11%. If you combine ETF assets with open-end assets, that share has grown to about 25%--more than double over the last 10 years, which is really stunning, especially in a low-growth, slow-growth decade, the decade we've had.

Benz: So, apparently one of the big losers in this flight toward passive products has been American Funds. It doesn't appear that that spate of outflows that they've had is showing any signs of slowing down.

McDevitt: No, it really doesn't. It's just been a very steady drumbeat of flows out of the firm, out of their funds. It's now been 36 consecutive months of outflows, and there haven't been real spikes. It's just been this very steady $4 billion to $6 billion a month. And we actually visited American in April, and believe me, they at least on the distribution side and the marketing side, they're very concerned, I think, about the outflows. But at the same time, though, they're not really changing who they are as a firm and they're not going to start launching trendy funds in order to chase assets. But at the same time, though, I think they're very aware of it, and I think they are looking at ways they can at least improve performance within their existing equity and fixed-income funds.

Benz: So, would you conjecture that it's just sort of like a bad product mix? I know you've said before that they don't have a huge franchise in fixed income, they've been losing market share there to other firms, and also that their portfolios are just more global. What is it that has investors leaving?

McDevitt: I think it's a combination of those things. It's kind of the product mix doesn't necessarily fit with what people are looking for today. And also they have had some struggles performance-wise over the last three years. Their average fund is roughly in the middle of its category. So performance hasn't been great recently, even though their long-term records still in general look very strong.

I think it also comes down to distribution. They do have fairly good representation in the 401(k) market and the defined contribution market, but they are struggling more with the advisor market. As you have more and more fee-based advisors going to ETFs as kind of their first choice, there is a new generation out there that I don't think American is necessarily connected with as well. I think they're still perceived in some circles as being kind of a load-based shop, even though most of the sales today don't really come through load-based funds. But they're still seen as kind of a transaction-based shop.

And also one final note is just, in the past, you had a lot of advisors who'd use American Funds for their entire book of business, and that's not happening anymore. Now they might just get a sliver of an advisor's book of business. An advisor might use one or two of their funds, but won't use a handful of funds and have them as the exclusive source of asset management for their clients.

Benz: Last thing I want to touch on with you, Kevin, is this DoubleLine juggernaut that we've seen; the firm's big Total Return Fund just continues to gather assets at a stunning clip.

McDevitt: It really does, and ... I don't want to say too much, because it's not a fund I cover directly, but I think in terms of our coverage as a firm, we have had concerns about the pace of inflows, because the style and the approach of DoubleLine is definitely nuanced, and some of the markets it traffics in don't necessarily have the capacity to handle tremendous inflows because, again, they are operating in some specialty parts of the market, especially when it comes to mortgages.

So, you do kind of wonder about the capacity of that fund, and if at some point all the inflows will have an impact, at least on how the fund is managed. I don't want to make any predictions on performance. But at some point you wonder if it is going to have an impact at all. But for the time being, right, those flows have just been stunning. Over the last 12 months, DoubleLine Total Return has taken in $18 billion in new money and $2.1 billion in the past month in June.

Benz: Kevin, thank you so much for sharing your insights. It's always great to hear from you.

McDevitt: Thank you, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.