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No Great Rotation Into Equity Funds Yet

Christine Benz
Michael Rawson, CFA

Christine Benz: Hi, I am Christine Benz for After a strong start to the year, equity-fund flows looked tepid in April, while bond-fund flows continue to be robust. Joining me to provide some color on the latest fund-flow data is Michael Rawson. He is a fund analyst with Morningstar. Mike, thank you so much for being here.

Michael Rawson: Thanks for having me Christine.

Benz: Mike, let’s take this category by category, starting with domestic equity. We had a really strong start to the year. A lot of people were saying it’s the beginning of this great rotation where we will see investors embracing equity funds, but domestic-equity-fund flows weren’t all that great during April?

Rawson: No, they were kind of disappointing, particularly if you back out passive flows. So, passive flows have continued to be strong; there have been pretty persistent strong flows into passive index-based products. Flows to active equity actually were negative last month. So it was a little bit disappointing. Certainly we had to back away from that great rotation story of flows going into active equity managers because like I said, if you take away the flows to passive products, equity flows were actually negative.

Benz: International equity was somewhat a brighter story, pretty robust flows there. What kinds of products are investors buying?

Rawson: Sure, well interestingly enough, they are still buying passive products when they go internationally, as well. Particularly Vanguard Total International Stock Market had very strong flows last month. I think there is some more willingness to invest in Europe, so these core stock funds, of course, because Europe is such a large economy, they will dominate most broadly diversified stock funds. So there are some flows going back into Europe and emerging markets continues to be very strong. And so not only are investors choosing passive products, they are also tilting toward dividend-paying funds and value-type funds. So Matthews Asia Dividend Fund had strong flows last month.

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Benz: So that’s an active product. That’s one glimmer of hope for the active managers, but they have been kind of few and far between it sounds like.

Rawson: Yes.

Benz: Let’s take a look at fixed income. Mike, you noted that flows there were fairly robust, but people aren’t necessarily choosing the big core funds that they were last year. They are buying some of the more specialized products. Let’s talk about some of the categories that have been the biggest asset gatherers in fixed income.

Rawson: Sure, so it’s really been bank loan. Bank loan, nontraditional bond, multisector bond, and world bond have been the categories which have attracted more flows. Flows into the core bond, the intermediate-term bond category, which were really strong last year, they are still positive, but they are a lot lower than what they were. But it's bank loan that’s really been dominating. Bank-loan funds are up about 3% so far this year where the core bond fund is about flat, maybe up 1%. The thinking with the bank-loan fund is that you are taking credit risk and you are also taking less interest-rate risk. So if interest rates were to rise, bank-loan funds potentially could hold up better. So they have been very attractive because in theory they should perform very well.

Benz: It is a pretty small category, but it has seen great big flows. I would like to look a little bit at nontraditional bond. That’s a category that is relatively new for us, and I know it’s kind of a grab bag of different strategies, but what's sort of the unifying theme among those nontraditional bond funds?

Rawson: Well, I think PIMCO Unconstrained Bond is a fund that comes to mind. That was one of the top-flowing funds last month. There is a fund where, as the name implies, is unconstrained in terms of the duration bets it can make. So you are giving more discretions to the manager to make selections in terms of where he feels interest rates are going to go and how he can position himself defensively. Of course, a bond index fund is just going to buy everything that’s in the index. You're not going to have any kind of defense in this in terms of a response to a change in interest rates.

Benz: Mike you did some interesting work where you looked at some of the core-type bond funds that have been getting flows. You think a lot of that is actually coming from target-date flows.

Rawson: Absolutely. So, Vanguard fund of funds; their Target Retirement Series are very popular. Any kind of target risk or target-date fund is going to get a pretty consistent flows month in and month out. Now those portfolio managers, every time they have an inflow of money they have to deploy that, put that to work, and they are going to try to get the allocations back to their target. Well, with the equity market up about 12% this year and the bond market about flat, those managers are allocating more money to the bond side to bring that side back up equal to the equity side.

So a lot of the money that’s going into, I think, core bond funds is coming from the target retirement series type of funds, target-date funds, target-risk funds. So I think if you back out the money that’s coming into core bond funds from this group of funds, the flows to core bond funds looks even worse. So there, again, it shows that when people are making an active choice, putting money directly into a fund, they are tending to pick the bank loan, the nontraditional type of bond categories, whereas it might be their target retirement series or target-date funds are going into the core bond funds.

Benz: I think there have been a lot of people watching the flows into bond funds and saying, "There go those dumb fund investors again." Maybe it's really just that investors like the target-date products and aren’t specifically picking the bond funds.

Rawson: Yeah, that’s a good point.

Benz: Mike, let’s take a look at exchange-traded fund flows and where we have seen money going over the past month for the year to date.

Rawson: Sure. So last month there was about $37 billion flow into open-end funds; about $8 billion went into ETFs. So in total it's about $46 billion. On the ETFs side, two of the ETFs which are real popular last month and really year to date is the iShares MSCI Japan and WisdomTree Japan Hedged. Of course, we know Bank of Japan announced quantitative easing. Japan's stock market's up about 20% or so for the year. It’s been a great run, so it’s particularly helped these two ETFs gain a lot of assets.

Also on the ETF side a theme that has been really strong is this lower minimum volatility. So we have this PowerShares S&P 500 Low Volatility ETF and iShares USA Minimum Volatility. Low-volatility stocks historically have performed better on a risk-adjusted basis than the broad market. And particularly now it’s a very easy story to tell to clients and say, "Hey look, these stocks are less volatile. You are going to get a smoother ride." So they have been particularly attractive in this environment where we have just come out of a period of strong volatility.

Benz: And I guess it's a question for you, Mike, is it a gimmick--because if someone is looking back on the past 10 years, you saw a couple of big bear markets during that time or at least the tail-end of one and certainly another big one in 2007 through 2009--are people being kind of sold a product that is fighting the last war?

Rawson: Well, I don’t think the low-volatility phenomenon is in itself a gimmick. The idea that now is the right time to buy it, certainly it’s an earlier sale if I'm selling to someone where I'm pitching this product because you can say, "We just came out of this massively volatile environment. Look how much better you would have done in a low volatility product."

Low volatility has some overlap with high-dividend-paying stocks--utilities, consumer staples--these are segments of the market which are extremely popular and have gained a lot of assets, and the valuations have started to look more expensive, relative to the more cyclical, more speculative equity sectors, which no one wants to buy those now because we've just come out of this period of high volatility.

Benz: Let’s take a quick look at where the money has been flowing out of? Precious metals would be one spot.

Rawson: Sure, gold. So gold was down about 8% in April. It was obviously a terrible month for gold. You would expect a lot of stability in gold. But I think part of what’s happening is that the inflation numbers just have been very benign, so I think some money is coming out of gold, thinking that maybe the quantitative easing in the U.S. is not having this rampant hyperinflation type of effect on the U.S. dollar. So SPDR Gold Trust had pretty large flows last month, outflows of about $7 billion or $8 billion.

Benz: And then quickly in terms of fund families that have been seeing the biggest asset-gathering operations, you’ve mentioned a couple of them, Vanguard and PIMCO.

Rawson: Yeah, Vanguard and PIMCO continue to attract more assets than their market share. So they are gaining market share. You have American Funds continuing to lose market share and T. Rowe Price, as well.

Benz: Mike, thank you so much for being here to share your insights.

Rawson: Thank you, Christine.

Benz: Thanks for watching. I am Christine Benz for