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Fund Flows Show Two Takes on Risk

Christine Benz

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

When it comes to fund flows, investors appear to be demonstrating a little bit of schizophrenia recently, with some investors gravitating toward bonds and some others looking to risky asset classes.

Here to discuss the latest trends in fund flows is Kevin McDevitt. He is editorial director for Morningstar.

Kevin, thanks so much for being here.

Kevin McDevitt: Thanks for having me.

Benz: So, Kevin, I'd like to discuss the ongoing trend toward bonds. It appears that we're still seeing investors showing a strong preference for bonds over equities. Why do you think that is? What are the drivers there?

McDevitt: Absolutely, there are a couple of drivers. I think the main one is just people are trying reduce risk in their portfolios. And you're seeing it on two fronts. One is getting out of equities, but then there is also a push, I should say, which is not necessarily tied to risk, it's more tied to the lack of return on money market funds.

It's amazing that trends we've seen since the Fed took rates to zero back in December of 2008. Ever since then you saw a huge push into short-term bond funds in particular.

So I think on one hand, again, it's risk aversion in terms of equities, but then even more than that perhaps it's money moving from money-market funds into short-term and intermediate-term bond funds.

Benz: So seeking a little bit of yield pickup. Whether that's a good idea or not, I guess we're not so sure about that, but…

McDevitt: Right.

Benz: …It's the trend we're seeing.

McDevitt: It's certainly understandable, but right, it's a different issue as to whether that's the most prudent use of your assets.

Benz: Right. So, in terms of the risk-averse group, I know that you mentioned to me earlier that you think that the Flash Crash may have been a little bit of an inflection point for some retail investors. Talk about your thoughts there?

McDevitt: Sure. Well, we had that strong rebound, that great rally in 2009, and you had maybe some investors trying to dip their toe back into equity funds. But things really turned on a dime in May. You started to see big outflows again, and I think in part that's due to the Flash Crash.

Again, on that very day, the market was only down about 3%, which in the scheme of things, is not that bad. But for some reason, or I shouldn't say for some reason, I think there was an intellectual or a psychological response to that, where investors felt like there was an issue of market manipulation. And I think there was somewhat of a lack of trust or a loss of trust in the equity markets.

So, I think for some investors after what they've faced in 2008, in the fall of 2008, and then this on top of it, the Flash Crash. I think for a lot of investors that was the last straw, and they said no matter what happens from here on out, I'm never going to get burned that way again.

Benz: So I want to talk about some of the riskier asset classes that you've seen investors embrace. Emerging markets is one, and that is emerging market stock funds and bond funds have seen strong inflows. Can you talk about what you're seeing there?

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McDevitt: Sure. I think there are a couple of things happening there, as you alluded to. I think one is just the desire for diversification. I think there are concerns that investors have about the strength of the U.S. dollar. I think they are worried about being locked into the U.S. I think also there are a fair number of investors who are perhaps under-diversified. They didn't have as much exposure three years ago outside of the U.S. and maybe this is part of that, a reallocation.

I think part of it, frankly, though, too, is also performance-chasing. You've seen great returns over the past decade in both emerging-markets stock funds and emerging-markets bond funds. So that's a bit of a concern there. You worry about people chasing those returns.

Benz: Right, right, and maybe not knowing the risks that are in those asset classes right now.

McDevitt: Right. I think you can get caught up in this idea of emerging-market growth is so strong, and in some ways they are recovering better than the U.S. economy is. But that doesn't necessarily mean there won't be volatility in those stock and bond markets.

Benz: Right. It could also be well reflected in current prices, too.

McDevitt: Absolutely, right.

Benz: So I want to discuss another topic, Kevin, the whole category of alternatives and what you're seeing there. It seems that there is a lot of investor interest in those categories, right?

McDevitt: Absolutely. We get questions about those areas all the time. What's funny, though, is that you're seeing strong flows into bear market funds, long/short funds, but frankly, the performance hasn't really – from what we've seen so far, the performance has not really been there.

Over the last three years, the S&P 500 Index is down about 7% annualized, but bear market funds are down I think more than 12% annualized over that same time period. In a way this is kind of the perfect test for them, you've had a really rough bear market, and you'd expect them to perform well, but that really hasn't happened.

But that said, what the irony is, is that you're seeing flows into these bear market funds, which have not performed terribly well, and outflows out of more standard allocation funds, for example, like moderate allocation has seen tremendous outflows while again you're seeing more flows into these alternative strategies.

Benz: How about in commodities and precious metals--what are investors saying with their inflows and outflows from those categories?

McDevitt: Sure. It's kind of a similar trend what we're seeing on the bond side, interestingly enough. Since the end of 2008, you've seen huge flows – relative to where they were before – huge flows into commodities futures funds and some flows, but to a far lesser extent, into equity precious metals funds.

But I think from an investor standpoint, they are seeing 0% yields or roughly 0% yields on their money-market funds. So, there is not a huge opportunity cost to going into a commodity fund, for example, which might have no yield at all. So, I think it's driven by the fact that again there is 0% to be earned on your money-market fund, but then also more broadly speaking, as a concern about potential inflation tied to the Fed funds rate being so low, and then also I think concerns about the dollar itself.

Benz: Okay. So I'd like to discuss the fund family view as well. Who has been a net beneficiary of some of those trends in terms of fund families, and who's been seeing the outflows?

McDevitt: Sure. The two big winners by a mile are PIMCO and Vanguard, and I think that just ties to the fact that they both have these very broad, very deep bond lineups, bond fund lineups in their families. So they have been tremendous beneficiaries of this.

Also, Vanguard in a way that's maybe not terribly obvious – while we are seeing big outflows out of stock funds, that's not really happening with index funds, and in fact, we've even seen inflows into index funds.

Benz: Equity index funds.

McDevitt: Equity index funds in particular. Total bond market as well, but on the equity side, it's been fairly strong. In terms of those who are losing out, the big loser here has been American Funds by far. Our colleague Russ Kinnel just came out with the unloved. That is the funds which have seen the biggest outflows, those categories have seen the biggest outflows over the last year, and by far the biggest categories are large value, large growth, moderate allocation, and that's American Funds.

Benz: That's their lineup.

McDevitt: That's their lineup.

Benz: Right. So, one last question for you, Kevin. I always look at this fund flow data and some people say, well, this is a contrarian indicator – what you see in terms of mutual fund flows. Are you concerned that investors buying bonds now may get burned and have we looked at any data to support what flows portend about future performance?

McDevitt: In terms of what we've seen in terms of future performance, you've got very, very low yield to this point, especially on things like TIPS funds Treasury Inflation-Protected Securities, you are seeing very low yields there and in bond funds generally, but we are also seeing, too, as we talk to world allocation managers, moderate allocation managers, you're seeing them on the margins shifting out of bonds and into equities. I think from their standpoint, they are seeing better valuations in many cases on the equity side versus the bond side.

I think from an investor standpoint, they need to be careful about where they are allocating their assets on the bond side. We talked before about increasing risk appetites. We are seeing much greater flows into emerging-market bond funds, but also into high-yield bond funds. I think investors should be careful, and think back to 2008, how badly those funds got hit at the time and there are concerns, I think, about declining credit quality in the high-yield market. So again, even though you are seeing strong returns in those areas, I think it's good to be wary.

Benz: Right. Well, Kevin, thanks so much for sharing your insights. We appreciate it.

McDevitt: Thanks for having me.

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