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Investors Haven't Left Equities for Dead

Christine Benz
Kevin McDevitt, CFA

Christine Benz: I'm Christine Benz for

Some commentators have been writing about the death of equities among small investors, but Morningstar editorial director Kevin McDevitt thinks that's premature. He is joining me to discuss the latest trends in mutual funds' inflows and outflows.

Kevin, thank you so much for being here.

Kevin McDevitt: Thanks for having me, Christine.

Benz: Kevin, one thing that we've been hearing is that investors have given up on equities. The flash crash and all the volatility in stocks have left investors retreating from stocks. Let's talk about what you see when you look at the data--do you think that that's a true assertion?

McDevitt: I think there is some truth to it, but it's certainly overblown at least the way it's being portrayed in the media. There have been outflows over the last five years in particular, but really, if you look at the outflows as a percentage of assets, they are really not as extreme as it's portrayed at times.

And just to put some numbers around that, U.S. stock assets--if you are including both open-end funds and ETFs--peaked in October of 2007. That's right when the market peaked as well, and assets then were about $4 trillion.

Now, not quite five years later, assets are still just under $3.8 trillion, which is  roughly a 6% decline. So you have seen a drop in assets, but again, it hasn't been anything catastrophic, and it's even less if you look at just outflows. Over the last five years combined outflows have been about $121-$122 billion; that's just a 3.2% decline from the beginning asset level. So, yes, there have been outflows, and the absolute numbers are big, but on a percentage basis, it's really not as extreme as is being portrayed at times.

Benz: So it sounds like what you think people are missing is that maybe they are not adding back in these very strong flows we've seen into passively managed products, especially ETFs. When you put them back into the mix, it's actually not been all that bad for funds?

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McDevitt: Exactly. As we've discussed before, it's been more this transition from actively managed funds to passively managed funds, and if you look at, again, just U.S. stock flows over the past five years, you see that borne out to some extent. ... Over the past five years you've had about $500 billion leave actively managed funds, but over that same time period, you've had $300 billion go into passively managed open-end funds and ETFs.

Benz: We've certainly seen that trend borne out by the fund families that have been the big winners and losers in all of this. Vanguard, we've been talking about for a while now, really being an asset-gathering machine. And then American Funds, which is an actively managed shop, has been dramatically losing money in terms of investor flows.

McDevitt: Right. They've really struggled, and unfortunately for American, they extended their consecutive month-streaks of outflows--it's 37 months this past month--and they had about another $4 billion or so go out the door, versus Vanguard, which had about $10.5 billion or so in inflows, and that's combining, by the way, both open-end funds and ETFs. So, [adding ETF flows] doesn't have any impact on American Funds, but it does impact Vanguard.

Benz: So, Kevin, let's talk about another big trend that we've been observing, and that is money flowing out of money market mutual funds and into bond funds. It sounds like that's something that in the month of July, and really for the past few years, you saw that trend persist--not necessarily out of money market funds, but certainly going into bond funds?

McDevitt: Right. As we've talked about before, I think that's really the far bigger story, and again it gives some perspective on what we're seeing on the U.S. stock fund side as well.

Just going back to what we discussed, we've seen ... outflows of about 3.2% from U.S. stock funds over the last five years. The decline from money market funds due to outflows has been 33%. It's a far greater migration out of money market funds, and most of that money, as far as we can tell, has gone into taxable-bond funds.

So again, to put some hard numbers around that, since just the end of 2008, so not even five years, you've seen nearly $1.2 trillion leave money market funds, and the overall asset base for all money market funds has gone from about $3.8 trillion to about $2.5 trillion.

Now over that roughly 3 1/2 year or so period, you've seen $900 billion go into taxable bond funds. So arguably the vast majority of that money leaving money markets has gone into taxable-bond funds.

Benz: It's easy to see why that's happening, right? The yields on money market funds are seemingly as low as they can go, and you are really in the red once you factor in inflation. But let's talk about some of the categories that investors have been adding assets to within fixed income. If they are indeed taking it out of money market funds, are they putting it in perhaps overly risky pockets of the bond market?

McDevitt: Potentially. Just looking at this year--and this year is, I think, fairly representative of what you've seen over the last five years--but just over the last 12 months, you've seen the vast majority of inflows go into intermediate-term bond funds and shorter-term bond funds to some extend, too. But intermediate-term bond has taken in a little over $100 billion for just the past 12 months, and more than $70 billion for just the year-to-date. Granted, you can argue that an intermediate-term bond fund is a good core holding for most investors, but certainly a big step up in terms of risk if you're talking about making the leap from a money market fund to a bond fund. [On the other hand,] you've seen far lower flows into short-term bond funds, which you would think of as ... the closest proxy for a money market fund. So just as comparison, over the last year, you've seen over $100 billion going into intermediate-term bond funds and just over $25 billion going into short-term bond funds.

Benz: Kevin, you also noted in your latest report that investors' appetite for risk-taking extends into junk bond funds and emerging-market bond funds, and some other areas. Let's talk about what's going on there and what the flows have looked like into some of those categories.

McDevitt: The other part of this is that there's been an increasing appetite for credit risk, again, I think, as you alluded to, in hopes of garnering some additional yield. And you've seen that across the board with high-yield bond funds, emerging-market bond funds, and the multisector category has also seen fairly strong flows.

But high yield, we'll just focus there for a moment, high-yield bond funds took in about $6.7 billion in July, and granted that was only the fourth-strongest month over the last 12, but to put that in perspective, it's also the fourth-strongest month over the past 10 years. So, to me, that was extremely striking, that the last four strongest months over the past 12 months would also be the ... four strongest months over the last decade.

Benz: What's going on in munis, Kevin? That's a group of funds that we've been watching closely. Are they seeing the same kind of robust flows that taxable-bond funds have been seeing?

McDevitt: Not to the some extent. They have certainly rebounded since inflows really fell off a cliff, and really you had a lot of investors pulling money ... at the end of 2010 into 2011, after a credit scare.

But since then, they've really returned to a steady state. You haven't really seen a spike in terms of municipal-bond inflows, but you've had very much of this steady-state. So now, you typically see municipal-bond funds in a $4 billion to $6 billion range each month, and this past month, inflows were about $5.8 billion.

Benz: Kevin, you also dug up some really interesting statistics about real estate flows. I'd like to hear your take on whether you think that's just good old-fashioned yield-chasing, similar to what we're seeing in some of the taxable-bond categories. Let's talk about what the flows have been and also what you think is driving them.

McDevitt: I guess if you are a contrarian, or if you're someone who is worried about the state of investors, you worry about some of the trends right now within real estate funds, and you're seeing that mirrored with taxable-bond funds, especially the credit categories.

Over the last two or three quarters, we've seen stronger inflows into real estate funds than we saw during the last boom in REIT funds, and that was in the mid-2000s, when REITs had fantastic returns coming out of the tech bubble. That was one of the strongest ... returning areas coming out of the tech bubble. And in the past three years, that's kind of happened again. REITs got just absolutely destroyed during the credit crisis, but coming out of the credit crisis, REITs and real estate funds have arguably been the strongest category over the last three or so years, and investors have responded. They've, again, plowed more money into real estate funds over the last two or three quarters than they ever did during the boom in the mid-2000s.

So, that's a bit of a concerning sign, especially when you look at the fact that Morningstar's equity analysts have real estate right now rated as the most overvalued sector within their coverage list. So you worry about people plowing money in at the top when it comes to real estate.

Benz: Performance-chasing, yield-chasing, high valuations--that can be a combustible mix.

McDevitt: Yes, it's a bit concerning.

Benz: OK. Kevin, thank you so much. It's always great to hear your insights on these latest trends in investor behavior. We appreciate you being here.

McDevitt: Thank you, Christine.

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