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By Christine Benz and Michael Rawson, CFA | 06-12-2014 01:00 PM

Investors Grow Cautious on Stocks

May was the worst month in over a year for flows to U.S. equities, while many core bond funds are receiving inflows as rising-rate concerns abate.

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

Although the equity market was relatively strong in May, investors weren't buying traditional U.S. equity mutual funds. Joining me to discuss what they were buying is Mike Rawson, a fund analyst with Morningstar.

Mike, thank you for being here.

Mike Rawson: Thanks for having me, Christine.

Benz: Mike, when you look at fund flow data, it looks like investors have been pretty tepid on at least traditional U.S. stock funds so far in 2014.

Rawson: May was the worst month in about 17 months in terms of flows to U.S. equities. There were actually outflows of about $6-$7 billion. Some of that may not have been a true reflection of investors' sentiment, but when you look overall so far this year, the first five months of the year, flows are down from what they were last year, and particularly for U.S. equities.

Benz: When you net it out and add back in what's been going on with index funds and ETFs as well as collective investment trusts, what do you see about investor sentiment, based on fund flows?

Rawson: I think investors are somewhat skeptical or cautious. You don't see the wild enthusiasm that maybe you saw a year ago. Flows are down.

A couple of trends we've observed is that, typically in the past, outflows for mutual funds were offset by inflows to ETFs. That hasn't been the case so far this year. In fact, there have been some outflows to some major exchange-traded funds.

The SPDR S&P 500 ETF (SPY) for example has had pretty big outflows, and there has been a market-share shift between the SPDR fund, which is the largest ETF, and a couple of its lower-cost, more-efficient competitors, such as the Vanguard S&P 500 Fund (VOO) and iShares S&P 500 Fund (IVV). Both of those are lower cost. Traditionally people chose the SPDR because it was more liquid, and it was the first, so it had more name recognition, but we are starting to see some investors switch to the lower-cost, more-efficient S&P 500 ETFs.

Benz: You mentioned in your recent report that we saw some flows coming out of U.S. equity traditional mutual funds and moving into what are called collective trusts. Let's talk about what collective trusts are, and also what you think is the possible reason behind this recent shift.

Rawson: Collective investment trusts are pooled investment vehicles. In that respect, they are similar to mutual funds. But unlike mutual funds, they are not subject to the same SEC reporting requirements. They don't have as much disclosure. Typically they are viewed as safe investment vehicles. However, they don't have the same level of reporting disclosure that a mutual fund would. So they have some lower administrative costs.

Occasionally you see large institutions or 401(k) plans offer CITs to their clients, because they have a lot of assets and they are able to pool their money and get access to this institutional type of account at a lower cost. The information is maybe not as publicly disclosed, but because it's a pension fund or a 401(k), they are able to do the due diligence and assess that this is a safe fund.

As you mentioned, last month and in April we had seen some flows from Fidelity products into collective investment trusts. What I find interesting about that is we've seen over the past several years a lot of inflows into passive products, and not as much growth in active products, potentially because of the expense ratio difference between active and passive. So as we are now starting to see some flows into collective investment trusts, it may be a way for an active manager to say, look, I can offer you a discount on this strategy, but I can't offer it on the mutual fund. If you are an institutional investor, I'm going to give you access to a collective investment trust at a lower expense ratio, but I don't want to cut my expense ratio on my mutual fund, because that's where a lot of my profits come from.

Benz: Switching over to fixed income, it's been a surprisingly strong year for the fixed-income markets, and investor flows show that investors are buying bond funds. What types of bond funds have they been buying?

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