Christine Benz: Hi. I am Christine Benz for Morningstar. In February, open-end mutual funds had one of their best months of inflows in two years. Here to shed some light on which categories investors have been gravitating to as well as what they've been shunning is Kevin McDevitt. He is editorial director for Morningstar. Kevin, thank you so much for joining me.
Kevin McDevitt: Thanks for having me, Christine.
Benz: Kevin, let's start with the headlines. Investors continued to pile into bond funds during the month of February, both municipal and taxable, but especially taxable. Which categories have investors been buying?
McDevitt: It's a similar story to the last few months, where intermediate-term bond funds and high-yield bond funds have seen the greatest flows. I believe we saw about $14 billion or so go into intermediate-term bond funds, and I believe about $5 billion or so went into high-yield funds.
Benz: You know, we're three years into this stock market rally. What are investors responding to in terms of being attracted to bonds at this juncture, and not really being as attracted to stock funds?
McDevitt: I have a feeling they are responding more to what happened in 2011 than what's happened so far this year. Clearly, that's the case because, again, we saw some modest outflows out of U.S. stock funds; a little more than $1 billion went out of U.S. stock funds. That's perhaps somewhat surprising, considering that the S&P 500 is up about 9% or so this year.
So, I think again, in terms of the flows into bond funds, it's more reflective of what happened in 2011. You can perhaps actually could go much longer term than that and say, well, taxable bond funds in general have done better than equity funds have over the last decade or so. I think there's probably a short-term dynamic to it, again, looking at last year, and then also a longer-term dynamic, as well.
Benz: Kevin, with this ongoing flow into bond funds, it appears that investors are saying they'd rather settle for a low but knowable return than risk greater losses in stock funds.
McDevitt: I completely agree. I think that's very much a part of it. Certainly, the other trends we've talked about before, too, in terms of demographics, have had an effect, particularly just the aging of the baby boomers. They are perhaps less willing at this point to take on extra risk via equity funds just by looking at trailing returns. Then, as you mentioned, their experiences through the recent credit crisis as well as in the 2000-2002 bear market have been deterrents.
But one interesting point along those lines though, and one thing I find somewhat surprising, is the popularity of high-yield funds in regard to the credit crisis. In the credit crisis in 2008, the average high-yield fund lost more than 20%. Of course, that's better than what you saw from the average stock fund. The average large-blend fund, I believe, lost about 37% in 2008. So, certainly, investors did fare worse in equity funds in 2008. But since then, you've had strong returns out of high-yield funds, but they've been even stronger for equity funds. However, the difference is that you've had net outflows out of equity funds since the credit crisis, but high-yield assets have pretty much tripled since the credit crisis. I don't want to say it's selective memory on the part of investors, but it's curious to me how they've been very much willing to go back into high-yields funds but not into stock funds.
Benz: Maybe some good old-fashioned yield-chasing going on there?
McDevitt: Yes, that's a good point, right. With the yields so low, with the 10-year Treasury at 2.0% and the yield on the Barclays U.S. Aggregate Bond Index at about 3.2%, you're getting much better yields out of high-yield bond funds. Whether or not you'll see better returns long term is a different question, but at least in terms of where we are today, yields are certainly more attractive in that sense.
Benz: You wrote in your recent commentary on fund flows, Kevin, that you wondered if this love affair with bond funds that investors have been having could end in tears. Can you expound on that?
McDevitt: Sure. It really goes back to kind of where yields are today and what your prospective returns are going to be going forward. Again, you could go back up to three decades and say, we've been in this very long-term trend of declining interest rates and declining yields, and that's really been the fuel behind bond-fund returns. And starting from where we are today, it's going to be very hard to repeat that performance, if not really impossible, to see those kinds of gains driven by falling yields.
Now, that's not to say, you couldn't have a scenario in the U.S. as has happened in Japan. Japan had very low yields 10 years ago, and they've only gone lower. So actually, Japanese bonds, especially for Japanese investors, have not been that bad of a place to invest. That same scenario could potentially play out here, but there is a lot of risk involved there, especially with the fact that right now, U.S. inflation is running about 3%. So, if nothing else changes, if inflation rates stay where they are and yields stay about where they are, most bond-fund investors will get no real return out of their investments.
Benz: Right. Now, Kevin, switching gears to equity funds, you mentioned that there has been sort of a steady drip-drop or maybe an even bigger flow of outflows from equity funds, and that continued in the first couple of months of this year. But you noticed that it had slowed down a little bit.
McDevitt: It has slowed down. Again, maybe not as much as you might expect, given that the market is up about 9% or so, so far year to date. As you know, we're off to one of the best starts, I think, in about 14 or 15 years. So, it's not surprising that it slowed. What maybe is somewhat surprising is that investors have not returned in greater force to U.S. stock funds. But again, that's been the theme we've seen the last five or six years. When the market has rallied in recent years, investors have not really tended to come back to equity funds the way they did perhaps after the 2000-2002 bear market, when in the first half of the 2000s, you did see more investors coming back to the market.
Benz: One thing that you've been drilling into has been this bifurcation between actively managed and passively managed products. We've been seeing big outflows from the actively managed equity funds, but in some cases, inflows into passively managed products, such as traditional index funds as well as exchange-traded funds.
McDevitt: It has been dramatic, and it seems to be only getting more so. During the past 12 months, you've had outflows out of actively managed U.S. stock funds of about $135 billion, while you've had inflows of about $20 billion into passively managed funds during the last 12 months. So, that's a $155 billion difference between those two numbers. As you said, if you add in ETFs, the numbers get even more dramatic.
Looking out over the past year, again, you've seen huge outflows out of U.S. stock funds at $114 billion out of outflows--that's combining both active and passive managed funds. But you've seen $43 billion in inflows into ETFs over the past 12 months. So again, you combine that $43 billion from ETFs, $20 billion into passively managed open-end funds, and that's a significant number, at $63 billion versus $114 billion out of open-end mutual funds, U.S. stock funds overall.
Benz: There's a lot to unpack there in terms of digging into those numbers, but is it your sense that investors are buying passive products because they feel that their active managers really didn't get the job done during the bear market?
McDevitt: Yes, that seems to be case. We've talked about this in past discussions, but it seems like in general, when it comes to equity funds, investors are much less inclined to take on manager risk. They're much less inclined to kind of give equity managers a free hand versus how in other areas we haven't seen that as much. You've seen actually investors giving managers more of a free hand in, for example, let's say the world-allocation category or the unconstrained-bond category, where you've seen investors actually gravitating to some of those areas that are very active.
But right, when it comes to equity funds, they haven't really shown much of a preference at all for active management, and certainly--this is something that Morningstar's Don Phillips has talked about for years--there really is a challenge being placed at the feet of actively managed funds, at the feet of active portfolio managers. In some ways, and again, they've done better so far in 2012, but I think longer term, they need to show that they can really respond to this challenge.
One thing that's interesting, too though, looking at this comparison between actively managed funds and ETFs is to look at outflows at a category level. One indication is you see investors leaving open-end funds for ETFs when you look at large-cap categories, and the least popular large-cap open-end categories--large value, large blend, and large growth--have actually been the most popular ETF categories during the past 12 months.
Benz: So, investors are just making that swap and saying, "We don't want the manger risk; we'll go with this low-cost kind of commodified product."
McDevitt: Right, exactly. It's not that it is necessarily leaving U.S. stocks or U.S. equities altogether. As you said, they are making that swap and then in this case, using the low-cost passive management or active management. Now, more in caveat to that would just be that unfortunately with our data, we can't see the underlying investor. We don't necessarily know. It could be a coincidence; we don't necessarily know that those are the same investors buying ETFs. But certainly from a high-level view, it looks like that's very possible.
Benz: Now, Kevin, with the international space, I think it's a familiar story to both of us here, where the emerging-markets funds continue to gather assets pretty aggressively, while it's not so much the case for some of the other categories.
McDevitt: Right, exactly. In February, as has been the case for months, pretty much all of these flows into international -stock funds were for emerging-markets equity funds. International-stock funds overall had about $3.3 billion in inflows, and, again, just about all of that went into emerging-markets equity funds.
We've talked in recent months about how that was somewhat surprising given that emerging-markets equity funds had a terrible year in 2011. There really was a pretty severe bear market for emerging-markets stock funds, but along with other parts of the equity market, they've really bounced back this year so far. Investors here seem like they really weren't dissuaded by what happened in 2011. So, they've actually enjoyed this nice runup so far in 2012.
Benz: In terms of fund families, you noted that Vanguard and Dimensional Fund Advisors have been a couple of the biggest asset gatherers, certainly in that emerging-markets space. DoubleLine is another firm that has been a big asset gatherer, even if it's not one of the largest fund shops out there.
McDevitt: Right. They've seen tremendous inflows. Especially their flagship fund DoubleLine Total Return had about $2.4 billion in inflows in February alone. So, very quickly, that family and the strength of Total Return has established itself, and relative to the bigger fund families, it's nowhere near among the larger firms. But in terms of just how quickly it's growing, it's been among the fastest-growing, if not the fastest-growing, fund family.
Benz: Obviously performance has been very good on that fund and the yield is quite high relative to other intermediate-term bond funds as well. So, I'm sure investors are responding to those two factors.
Benz: Well, Kevin, thank you so much. It's always great to hear from you and explore this intersection between funds and investor psychology. Thanks a lot for sharing your insights.
McDevitt: Thank you, Christine.
Benz: Thanks for watching. I am Christine Benz for Morningstar.com.