Performance and Cost Driving Assets to Passive Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors continue to lavish assets on passively managed products. Joining me to discuss this and other trends in the realm of fund flows is Alina Lamy, she is a senior quantitative analyst with Morningstar.

Alina, thank you so much for being here.

Alina Lamy: Hi, Christine. It's a pleasure to be here.

Benz: One thing we seem to always talk about when we sit down to talk about fund flows, at least over the past several years, is the fact that ETFs and other passively managed products have been getting the lion's share of assets. This has continued into 2017's first half, especially in the realm of equity products. Let's talk about what you think is driving that phenomenon.

Lamy: It's still a trend. It still hasn't changed. It's still a question of two factors, performance and cost. Investors have been moving into index funds and ETFs because they are less expensive and they offer the market return, which has been pretty good year to date. What's really interesting though is that U.S. equity active funds have performed a little bit better year to date, but still investors have been taking money out of them. It's that sort of inertia; they have been taking money out for such a long time, they are going to just keep doing the same thing, investors are slow to react. But it will be interesting to see if active funds continue outperforming if that will make a difference in flows for the remainder of the year.

Benz: A lot of the flows seem to be driven by advisors, that many advisors are saying, well, I'm going to put my clients in very low-cost products and that means maybe I can take a little more of the total fee for myself. Do you see that trend abating anytime soon?

Lamy: I don't think so, especially with the fiduciary rules now it's pretty much an uncertain future. We'll see what happens. But in general, the good advisors who have a lot of clients, I think they kind of apply that standard already.

Benz: OK. Let's talk about international. This historically had been one area where if you talk to investors, they might say, well, this is one space where maybe I think I'll use some sort of actively managed product. When you look at flows today, not necessarily the case. Investors are buying passives here as well.

Lamy: In international equity, flows into active are positive. So, there is a little interest in that. However, the majority of flows are going into passive. So, this seems to be a phenomenon affecting equity funds mostly, both U.S. and international. Performance has been really good, especially in emerging markets. So, I think, it's a question of two factors here as well, performance chasing and diversification. And in general, a lot of flows have been going into the foreign large-blend category and that's concentrated in Europe. So, it looks like investors are looking for further growth in that area.

Benz: OK. And it does look like diversified emerging-markets funds have been getting pretty good inflows as well, too?

Lamy: Pretty good because of the very good performance.

Benz: Yeah. OK. Let's look at fixed income. Bond funds, in general, have been seeing very good inflows. I'd like your take, Alina, on what you think is driving that trend. We've had a great equity market. Why are bond funds getting significant inflows?

Lamy: It's precisely because of that great equity market. The U.S. bull market has been going on for such a long time that it seems the investors are starting to fear it may end soon. So, it's again a question of diversification on two fronts. As we were talking a minute ago, in the equity area, they are diversifying internationally. And risk-wise, they are diversifying into lower-risk assets, which is bonds, and they also have income-producing abilities.

Benz: Right. One thing I know you noted in your latest fund flows report is the fact that active funds have actually been holding their ground in the fixed-income space in contrast with equities where many investors are focusing strictly on the passive products, some of the active bond funds are actually getting pretty decent inflows?

Lamy: It is a very different picture from U.S. equity funds. It seems that fixed income is the silver lining of active management these days and that goes to show that investors value a fixed income manager's expertise a lot more if they are willing to put money into those funds.

Benz: Is part of the issue that the active funds' yields are oftentimes a little bit higher because they have a greater proportion in, say, corporate bonds relative to the big index funds?

Lamy: Yes, and in general, there are so many more bonds out there to choose from. So, it seems that the active manager's skill in choosing and putting a portfolio of bonds together is of much greater value to investors than in equity where it's pretty much it's the market, there's an index for the small, for the medium and the large, for everything. There's pretty much an index for everything.

Benz: OK. We've been talking a lot about the passively managed products garnering flows and this ports over to the fund family space as well, where that Vanguard juggernaut continues. We won't talk about it today because I think we're really like a broken record on this topic. But iShares getting very good inflows on its passively managed lineup. Fidelity, I noticed, was in the report, though it's losing assets on the actively-managed equity side in particular, its passive products have actually been gaining assets.

Lamy: Fidelity is a great example. So, it's a traditionally active company who has been expanding into the passive arena. And guess what they did? About a year, exactly a year ago, they decided to lower expenses on about 27 of their index funds and ETFs. And that was the catalyst. Right after that they started getting higher and higher inflows into those passive offerings. So, if you have quality funds, which Fidelity has, and you get down to a reasonable level of cost, the money will come. Fidelity illustrated that.

Benz: Yeah. It seems like a lot of these players are saying, OK, Vanguard, we're not going to go quietly, whether it's Fidelity or Schwab. Let's look at some of the firms that have been losing assets. Franklin was close to the top of the list. Let's talk about what's being going on there.

Lamy: Franklin has been really hard hit on the active side with two of its funds, the Templeton Global Bond and Franklin Income, they had really severe outflows. And they are not bad funds at any rate, but they had severe performance swings and it seems that investors don't like that. But on a more positive note, Franklin is also expanding in the ETF area. I think, in May, they just launched a few strategic beta ETFs. So, we'll have to see how they deal with those.

Benz: Franklin perhaps playing a little bit of catch-up in the ETF space?

Lamy: They are.

Benz: OK. Let's look at a couple of firms that we had been watching off and on over the past few years because they were seeing pretty substantial asset outflows. Both PIMCO and American Funds seem to have stabilized a little bit on the fund flows front.

Lamy: PIMCO has made a great recovery. I mean, I just think about where they were three years ago when I was writing about them, when Bill Gross left and Total Return just had the most severe outflows ever. But now they've really, really been able to benefit from the fixed-income trend, from investors going into the taxable bonds space. And the main fund they've been able to do that with is PIMCO Income. It's a diversified multisector bond fund, and investors really like it.

And from American Funds, I think the three funds that were really attracting inflows for them were their Balanced Fund, their EuroPacific Growth Fund, and their Bond Fund as well; so, an allocation fund, an international equity, and an intermediate-term bond. So, those are active funds that have been reaping the benefits of the international equity and taxable bond trends we were talking about earlier.

Benz: OK. Alina, always interesting to talk about fund flows with you. Thank you so much for being here today.

Lamy: Thank you, Christine.

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