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By Christine Benz and Michael Rawson, CFA | 09-11-2014 10:00 AM

'Great Rotation' Into Stocks Runs Its Course

Investors have been putting money back into bond funds as interest rates have unexpectedly dropped this year.

Christine Benz: Hi, I'm Christine Benz from Morningstar. Has the so-called great rotation fizzled out? Joining me to discuss that topic is Michael Rawson, he's an analyst with Morningstar's manager research team. Mike, thank you so much for being here.

Mike Rawson: Thanks for having me, Christine.

Benz: Let's take a look at this: There had been this much-ballyhooed rotation into equities. We're seeing strong flows out of bond funds going into equity funds. You say the most recent data run, looking at fund flows, does not show continued strength in equity fund flows.

Rawson: You are absolutely right. The great rotation certainly did happen. We started talking about it at the beginning of the 2013--that people had anticipated for the longest time that all of this money has gone into bond funds, and at some point, this is going to end with interest rates being so low that people are going to turn to equities. And when the Federal Reserve started talking about removing stimulus in June of 2013, we finally saw the great rotation: Money came out of bond funds and started going into equities a little bit.

But what's happened recently is that the equity market really appears fully valued. Investors aren't as enthusiastic about going into equities. Interest rates have started to come down, and so investors have put money back into bond funds. So, the great rotation certainly happened in 2013, and it appears to have run its course. Every month this year over the past eight months, bond fund flows have exceeded U.S.-equity fund flows, which is really quite surprising given that a year ago no one would have predicted that. People would have said interest rates are going to continue to rise and that hasn't been the case.

Benz: Another trend that you've been monitoring has been this flow into passive-equity funds. When you factor them into the mix and look at passive-plus-active equity, are flows still pretty disappointing recently?

Rawson: So, in U.S. equity they are. There are negative flows to the active U.S. equity and positive flows to passive U.S. equity--mild. But what we are seeing, where the money is really going is the international funds and sector funds. Sector funds are a smaller subset of the universe. But we split those out from U.S.-equity funds because they tend to also hold a lot of international stocks; they tend to be industry focused, so they go across borders.

Sector funds are a smaller part of the pie, but they are a growing part of the pie because investors are seeking out these funds often trying to get some yield. So, we see some popular sector funds, such as real estate investment trust (REIT-type) funds and master limited partnership funds. These funds have gained in popularity, and flows have continued to go into international markets.

Last month, that pulled back a little bit as we saw Europe had negative GDP numbers, and so some of the inflows that Europe had been getting came back in August. But overall for the past eight months, flows to international funds have been very strong.

Benz: So, I think that investors might be confounded by this, given that U.S. equities had until very recently generally outperformed foreign-stock funds. What do you think is driving the interest in international?

Rawson: I think it's part of an allocation story. The U.S. market has appreciated so much. Investors have a large allocation to U.S.-equity funds just from market appreciation--even if they haven't added money into those funds overall. In 2013, the market was up 30%, so your assets in U.S.-equity funds were up 30%.

The developed European markets and developed Asia haven't kept up with the performance of U.S. funds. So, from an asset-allocation standpoint, investors have been allocating to those international markets as a way of catching up where they had underinvested, perhaps, in the 2011-12 timeframe.

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