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Risk-On Mode Continues Into New Year

Christine Benz
Michael Rawson, CFA

Christine Benz: Hi, I'm Christine Benz for January has historically been a very strong month for mutual fund flows, and 2014 was no exception. Joining me to discuss the latest data on the topic is Michael Rawson. He's a fund analyst with Morningstar.

Mike, thank you so much for being here.

Michael Ross: Thanks for having me, Christine.

Benz: Mike, first let's discuss these cyclical factors that tend to encourage flows in the early part of the year. What's going on there? Why are investors doing their buying?

Michael Rawson: So, as you mentioned, January is a strong month for flows historically, and our data going back to 1993, January tends to be stronger than the rest of the year. April is the second strongest month. And if you look at January and April, those two months are, I think, tied into the Internal Revenue Service rules in terms of investing in your IRA or your 401(k); you can make lump-sum contributions into an IRA starting in January for the next year. Of course, April is the deadline.

Benz: For the previous year.

Rawson: Exactly, it's for the previous year. So, those are two months where people are motivated to invest.

You also have a lot of companies doing either 401(k) deposits or bonus payments coming through in January. January just historically has been a strong month, and maybe that ties into some behavior we see in the market. But certainly, last month we had strong flows, so again, it ties into this cyclical phenomenon.

Benz: And maybe stoked a little bit by very strong market performance in 2013?

Rawson: Absolutely.

Benz: Let's look at the categories. Really, across the board, you saw quite strong flows. Even into categories that were pretty unloved last year, like muni bonds.

Rawson: Yes, everything pretty much had inflows except for commodities. So, municipal bonds had, I think, their first inflow in about a year, which was surprising.

Benz: Not a big inflow.

Rawson: Not big, but it was positive. Equities, again, were very strong as they were in all of last year. U.S. equities did well, but the breadwinner was really international equities. People were investing internationally; there were very strong flows there.

Benz: And why do you think that is, because international-equity funds underperformed U.S.-equity funds last year?

Rawson: International didn't do as well as the U.S., but the U.S. just did spectacular; 33% return for the S&P 500. Developed international markets actually did OK. They didn't do as well as the U.S., but if you were in a developed international fund, you probably are happy with your performance. And because of the European financial crisis which happened a little bit after U.S. financial crisis in 2009--the European financial crisis kind of dragged on--I think a lot of investors sat on the sidelines and avoided Europe. People were concerned about the euro itself. So, a lot of people stayed from Europe.

Now, the economies are improving there. The stock market performance is better. I think people are going back and kind of catching up where they hadn't been putting money into Europe before. Now they're catching up and putting that money back to work in Europe. And especially, Japan. Europe and Japan are kind of the two heavyweights in the developed space. Japan announced a lot of reforms and that's gotten a lot of people excited about what's going on there.

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Benz: When you drill into which funds are receiving the biggest flows, do you see any trends, Mike, this is among international-equity funds, in terms of passively managed products or active products? Which types of products are investors choosing?

Rawson: Christine, we've talked a lot over the years about how passive in the U.S. is just really dominating. In developed international markets and in emerging markets, it's not as strong. Active is a little bit stronger. The flows that we're seeing recently are tending to go to active products. A lot of people are skeptical of the indexed products in emerging markets. There is where you'll see a lot of more innovation in terms of what we call, smart beta or a non-market cap-weighted, because people want to avoid those conglomerates that aren't really close to the emerging market and consumer.

So, the flows that we're seeing are primarily going toward active funds. One fund that stands out is Oakmark International.

Benz: It's closed.

Rawson: It's closed. So it's closed to new investors; existing investors can still add apparently because they put in $1.5 billion last month, which are strong flows. Oakmark, of course, just had phenomenal performance; the fund continues to get flows. So, a lot of active funds are getting flows internationally.

Benz: One story I know that you've been watching, Mike, and you touched on it is, the fact that we have not seen a strong appetite for developing markets after investors had been kind of on a buying spree for emerging markets in the years before. What do you think is driving that? Is it just performance?

Rawson: I think it's performance. I think it's momentum-chasing; a lot of people are looking in the rearview mirror, particularly, I hate to say, but financial advisors, those people who're supposed to have the steady hand and probably know better, they're saying, "The performance is narrow; I'm getting out. I think performance might get worse. If the Fed tightens anymore, performance is potentially going to be bad in emerging markets."

So they're a little bit shy. They're pulling out. And I think they should probably stay the course. If you look at it, a lot of ETF flows are pulling out of emerging markets. The mutual fund investor, which is the retail investor, tends to still be putting money into emerging markets. I think it's the right thing to do. You want to buy when things are low and not after the performance has been really good. I mean, as [Morningstar director of fund research] Russ Kinnel would always say, "Buy the unloved." And I think it might be early to go into emerging markets, but I think if you have a five-year time frame or longer, you're better off there.

Benz: And you also noted that emerging-markets bonds have seen outflows; not just the stock funds?

Rawson: Yes, so again, that's the Fed. The Fed has hinted that they're going to continue to, not tighten per se, but maybe pull back on the stimulus efforts. And a lot of people are concerned that this is going to impact emerging markets because it has historically. But if you look, those historical comparisons were based on a time when emerging-markets economies were much more fragile. They are a lot larger now than they were in the past. Their economies and their balance sheets are in a lot better shape. So I think people should really think twice before they follow that old knee-jerk reaction, where whenever the Fed is going to move, they're either going to buy or sell emerging markets. I think we need to rethink that a little bit.

Benz: Emerging-markets bond funds were actually a rare exception in terms of investors being in risk-off mode; in general, investors were in risk-on mode when it came to their bond funds last year.

Rawson: Yes, risk-on in terms of, "I want to get away from interest-rate risk and sell those core bond funds." PIMCO Total Return was out of the window. And they wanted to get into something which certainly, traditionally, would be considered riskier, whether it'd be nontraditional bonds where the portfolio manager can change the duration [a measure of interest-rate sensitivity] or go a long and short on different parts of the yield curve or the credit curve.

Secondly, these bank-loan funds have gained a lot of popularity because they seem to offer the best of both worlds. I get a little bit of credit risk, and I'm not taking interest-rate risk because I have floating rates. Those two categories again, are attracting strong flows. And it's been almost a year now that they've been doing this, and it's really unprecedented because these are two relatively new categories.

Benz: Performance has been decent certainly in the bank-loan space; high yield has been great. But you've been cautioning people to just really know what they own if they're venturing into some of these noncore fixed-income types.

Rawson: Yes, you have to remind yourself, "Am I going into fixed income for performance? Am I chasing performance here? Or do I want to take my risk in equities and use my bond allocation as ballast in my portfolio to reduce volatility?"

You have to think about it that way because, if you start picking these more exotic funds--which the fund companies, they want to sell us them, because they're new, they have higher expense ratios, and they offer a promise essentially of "These are untested, but we think they should do well,"--you have to ask yourself, "Can I get that kind of exposure through equities?" And certainly last year, if you say to yourself, "I'm afraid of equities so let's go into these nontraditional bond funds," well you would have been better off taking a little bit of equity exposure because the market did so well. So, these funds offer credit risk. They don't have as much protection when equity markets sell off.

Benz: It sounds you probably think some of the outflows we've seen from the core fixed-income products that maybe do have a little bit of rate sensitivity, you think maybe that's overdone for investors who are looking to build balanced portfolios?

Rawson: It was certainly overdone at the beginning of the year; you look at the 3% on the 10-year Treasury, right at the end of the year. That fell, and now we're down to like 2.6% or 2.7%. I think it had gotten a little bit overdone. A 3% 10-year Treasury rate seems pretty attractive. So, it's already backed down a little bit from that. Again, I would think long term, we don't see inflation on the horizon, and once inflation ticks up, then the Fed really has to act. But right now, inflation is actually too low, not too high. So, I don't think the Fed is going to push to have rates higher anytime soon. Of course, that's speculative.

Benz: I want to touch briefly on alternative funds, retail mutual funds that use alternative strategies. You mentioned that flows have been decent there. What types of products are investors looking at?

Rawson: Here, again, it's the same thing that we see in bond funds. People are taking on riskier segments of the bond market because they don't want to go into stocks or at least they didn't, let's say a year or two ago. They said, "I want to get a little bit of exposure to some risk, but I'm still shy about going into the stock market." So, with alternatives, they're going into long/short products or market-neutral products. These are funds which should do well when the equity market does well, but it's going to have a little bit of hedge there. It's not 100% equities. It's taking maybe a more measured approach. Again, investors are probably paying higher fees for exposure they could build themselves just with equities and traditional bonds.

Benz: A good, old-fashioned balanced portfolio.

Rawson: Right, right.

Benz: Mike, you have touched on PIMCO's travails that it's been seeing big outflows from the core PIMCO Total Return product. Let's talk about what else is going on at PIMCO. We've seen some manager changes recently. Do you think that may hasten the pace of outflows at PIMCO?

Rawson: It's difficult to say/ Obviously PIMCO does a lot of business with the retail investor, but they also have a lot of institutional clients. And institutional clients, they tend to be very shy about a portfolio manager change. Often, these are investors who use a consultant to make their investment decisions for them. Consultants like to see stability in the portfolio managers because it gives them more predictability.

So, you may see outflows particularly on the institutional side or separate accounts. I would recommend for retail investors to stay the course. PIMCO obviously has a large staff. One or two portfolio manager changes isn't going to be that damaging. But one thing that I think is interesting about PIMCO and the pressure that the firm is under, they did have very strong outflows last year, but what hurt them more is the fact that PIMCO is a bond shop and the equity market was up 30% last year. So, if you're American Funds, Vanguard, or JPMorgan, your assets under management have grown, not 30%, but somewhere close to that, and PIMCO didn't participate in that upswing in the market.

A lot of fund managers--American Funds is a good example--have had outflows, but their revenue from a firmwide perspective is actually up despite the outflows because the market is up so high. For PIMCO, that's not the case. The firm had outflows and did not have the appreciation. I think that puts the firm under pressure. I think it's not a coincidence that so many people are leaving.

Benz: I know, they've been trying to build up that equity lineup, but the flows just haven't been there yet.

Rawson: No.

Benz: On the flip side, Vanguard, this juggernaut, looks like it cannot be stopped. We're seeing just tremendous flows, certainly in 2013, and they continued into January.

Rawson: Vanguard is a firm that Morningstar generally things highly of. We have our stewardship ratings which we take very seriously. We spend a lot of time thinking about the firm and not just the individual funds. Vanguard is positively rated in terms of the parent company, but there are some other firms which are fighting it out for second place, if you will: DFA, iShares/BlackRock, JPMorgan, MFS, and Putnam. These are firms that, certainly JPMorgan and MFS, are doing a good job selling active funds, whereas iShares is dominant and DFA [are firms viewed as mainly sellers of] passive products. JPMorgan and MFS are attracting inflows into their active products. So not all funds are losing money in active. Some funds and fund families are doing well in active, and JPMorgan is one of them.

Benz: I was surprised to see a Putnam fund make the list of biggest asset gatherers. It's been a while since Putnam has had a winning fund in terms of new flows.

Rawson: They're still there, and I think they've learnt from what MFS has done over the last several years. I think you'll see more of Putnam in the future.

Benz: Mike. Thank you so much for being here to provide a recap.

Rawson: Thanks, Christine.

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