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By Christine Benz and Michael Rawson, CFA | 07-14-2014 10:00 AM

Investors Remain Skeptical of Stock Funds

Despite equities’ strong returns, investors remain unexcited about stocks and instead continue to put more money to work in bond funds.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Despite fairly strong U.S. equity market performance, investors have continued to show a preference for bond funds. Joining me to discuss the latest asset-flows data is Michael Rawson. He is an analyst with manager research for Morningstar.

Mike, thank you so much for being here.

Michael Rawson: Thanks for having me, Christine.

Benz: Mike, we've been watching this trend for a few months now. We've seen relatively decent performance for U.S. stocks so far in 2014, but investors are buying bond funds. Why do you think that's happening?

Rawson: Just taking a look at the stock market, last month was the second month in a row where we saw outflows from equity mutual funds. And if you get back in ETFs, the inflows are mildly positive. But for the most part, mutual fund investors were pulling money out of the U.S. stock market. I think that has to do with the fact that the stock market appears to be fully valued. If we look at our price/fair value estimate, driven by our equity analysts, the stock market is at 103% of fair value, so the future returns are maybe still positive but not as good as they would have been maybe a year or two ago.

I think investors now are maybe a little more skeptical about putting money into the market. Then if you go back, after the financial crisis, there were outflows from stocks, but they weren't that strong. It was kind of mild, so we saw mild outflows. Over the past year, we've seen mild inflows. Now it's turning again to what might be outflows. So investors really are not that excited about stocks at this time.

Benz: To the extent that they are adding to U.S. equity though, it does appear that they're showing this preference, which we've been observing for a few years now, into exchange-traded funds and index products.

Rawson: That trend continues. ETFs are getting strong flows, not as strong as they were in the past but they are still getting strong flows.

Benz: Let's take a look at what investors are buying this year when they are buying bond funds. They do appear to be buying some of the core type fixed-income funds, correct?

Rawson: Sure, which is really a surprise. A year ago, there was about an $80 billion outflow from core intermediate-term bond funds, and this all started in May and June of last year when the talk about the taper really ramped up. Now you're actually seeing inflows into these categories. It's quite surprising because we would have expected interest rates to kind of continue to rise, but they haven't. Interest rates have stabilized. If anything the longer rates have come down a little bit, and you see investors, maybe not wanting to put money into stocks, so they are putting money into bonds and rebalancing into bonds, which is probably a good thing.

My concern, though, is that you could have another knee-jerk reaction once interest rates start to rise.

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