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Investors Flock to Foreign-Stock and Noncore Bond Funds

Christine Benz
Michael Rawson, CFA

Christine Benz: Hi, I'm Christine Benz for After losing assets for much of 2013, flows into bond funds picked up steam in February. Joining me to discuss the latest asset-flows data is Michael Rawson; he is a fund analyst with Morningstar.

Mike, thank you so much for being here.

Mike Rawson: Great to be here.

Benz: Mike, I guess, I wasn't surprised to see that equity funds saw fairly decent flows in February. I was surprised to see that taxable-bond funds and even municipal-bond funds saw some inflows during the month. What do you think is driving that?

Rawson: I think it's really the uptick in rates that we've had. At the end of 2013, the 10-year rate hit about 3%. That starts to look pretty attractive, relative to what we've seen in the last couple of years. I think a lot of the investors who are selling bonds in anticipation that rates would rise, are thinking, "OK, rates have already risen. I'm not going to continue to sell bonds."

I think there has been some stabilization there.

Benz: Investors think maybe the worst is over in terms of rising rates?

Rawson: At least in the short term, I think so. It's hard for me to envision the 10-year rate going up above 3% to 3.5% or 4%. I think that's little bit too high given that the Fed is still anchoring short-term rates near zero percent, so I think we'll probably tread water here at this level for some time.

Benz: Let's talk about the types of bond funds investors were buying. The intermediate-term bond category, you noted, still saw pretty tepid inflows, if positive at all. But some other categories were generating interest.

Rawson: Yes. The core-bond fund categories, there were essentially no flows. It was flat, but the noncore categories which we talked about a lot over the last several months--nontraditional bond, bank loan, high-yield bond--these are categories which are just continuing to see inflows. In fact high-yield bond had a very strong month last month, and I think there it's people are looking for some protection against rising rates and some credit spread to give them a little bit of extra income.

Benz: That nontraditional bond category, you have noted has been seeing a lot of interest, but PIMCO's fund, which had been one of the biggest asset gatherers, actually has been seeing some outflows?

Rawson: Well [PIMCO Unconstrained] was so popular, it's one of the reasons why we kind of created the category several years ago, and it was the category leader. However, it fell in hard times last year. People were buying this fund thinking, "If interest rates go up, my bonds are going to lose money. I got to prepare for that. So I want to go into something defensive."

This was sold as a fund that would do well if interest rates did go up; then it didn't hold up. In fact it had a negative return over the past year, so investors have been fleeing the fund and saying, look this isn't what I signed up for. They are going into couple of other funds, those include [JPMorgan Strategic Income Opportunities, BlackRock Strategic Income Opportunities, Goldman Sachs Strategic Income], so these are funds that actually had positive returns over the last year and are billing themselves the same way that they are going to hold up better if rates rise.

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Benz: Let's discuss that PIMCO story more broadly. PIMCO as a firm has been seeing outflows not just on PIMCO Unconstrained Bond fund, but also on PIMCO Total Return. There have been lots of headlines and the well-noted departure of Mohamed El-Erian. There is lot of news flow around PIMCO, and investors appear to be pulling their assets [from those funds].

Rawson: Sure. Over the past year, PIMCO has lost about $60 billion due to outflows, which is pretty tremendous. What's even worse still I think and what has put more pressure on the firm's management is their loss of market share. So, they are a bond shop. Bonds have been flat over the past year, so their assets haven't risen. If you're an American Funds or Fidelity or Vanguard, with the equity market up so much over the past several years, your assets have gone up. So even if you haven't raised expense ratios, your fee revenue, your income, your salaries that pays all your bonuses has gone up. So, most mutual fund firms are kind of in a good place right now. But that's not the case with PIMCO. Their assets are down and they haven't gained from the market appreciation that the rest of the industry has gained from. So I think that's put a lot of pressure on the management of PIMCO.

Benz: I know they have been trying to grow that equity piece, but it's still a pretty small share of their overall pie.

Let's talk about sector funds, Mike. We haven't really discussed them in the past, but you noted in your recent report that actually the flows have been pretty good into sector funds. Let's talk about the types of funds investors are buying. Are these ETFs? Are they traditional funds? Which funds are investors sending their money to?

Rawson: Interestingly, it's both. Now sector funds, Morningstar traditionally views these as kind of satellite holdings. These aren't really core. You wouldn't want to go and buy all 10 sector funds and just hold them. Well you might as well just buy a broad equity market fund. So these are more tactical. People have a view on health care or they have a view on technology, so they are going to buy one of these funds, or they might like an individual active manager. So, both mutual funds and sector ETFs are a relatively small part of the overall fund industry. But they've gained a lot of flows, and I think a lot of financial advisors are using these to be little bit more tactical. They see the market maybe as fully valued. So they're going to say, I'm going to avoid energy, and I want go into tech or whatever the case might be.

Fidelity of course is well-known for having a lot of active sector funds, a lot of well-run funds. Last year they launched sector ETFs, and those have actually gained quite bit of assets in a very short period of time. The whole sector investing theme is kind of coming to more prominence, and again Morningstar views these as really more tactical type of holdings, not something you would buy and hold indefinitely because it's not cost-effective in the long run.

Benz: And also, if you have a well-diversified portfolio, you're probably getting a lot of sector exposures.

Rawson: Oh yes, you already have exposure to tech in a broad index fund. There's no need to use these individual pieces. Again, the downside of these is that, financial advisors or individual investors may be over trading them, thinking that they can outperform the market by really speculating, so I would caution against using them. But I think there are a lot of good tools out there for you to use low-cost and efficient ways to get access to certain sectors.

Benz: Let's talk about international-equity funds. February was another month in which they saw very strong inflows. What do you think is driving that appetite for international-equity funds, and what types of funds are investors buying?

Rawson: Certainly the recovery in Europe and Japan is driving a lot of inflows into those two economies. In fact last month was the first month of emerging-markets outflows from mutual funds in three years. It was pretty surprising to see. We've talked about this trend, where ETF investors have been selling emerging markets, mutual fund investors have been continuing to buy, but last month the mutual fund investors finally capitulated and said, "Enough's enough; there's no momentum here. I'm going to trim back on my purchases of emerging markets."

So, I think what's driving that is a lot of sentiment among U.S. investors that "I have full exposure to U.S. stocks and U.S. bonds, but maybe my portfolio could still use some international exposure." When you talk about the home-country bias, it's important for people to be fully diversified, and particularly over the long term if you're bearish on the U.S. dollar, if you want some diversification, international stocks and bonds are a good way to achieve that. And we recommend those types of products even more so than a currency fund. A currency fund, again, is not something we would consider core. You can get currency exposure through international stocks and bonds which are productive assets. It's good to see strong flows there, particularly in Europe and Japan where the economies have stabilized.

Benz: We touched on PIMCO, how they have been seeing some outflows and struggling a little bit. Let's talk about the opposite, Vanguard yet again in February had a very good month? What is driving investors' appetite for Vanguard funds and ETFs?

Rawson: There are two major trends that have gone on in the industry over the long term which have helped Vanguard. One is the acceptance of index investing. Obviously, when Jack Bogle started Vanguard, index investing was just unheard of. In fact, some people even criticized it as being un-American. While clearly there's a big role for index funds to play in people's portfolios, Vanguard has been on the right side of that trend. The second trend that they've been on the right side of is this move toward fee-based financial advisors. Vanguard funds don't have a load. You're not going to have high 12b-1 marketing fees. You basically just get what you pay for. You're not buying a sales commission which is going to be kicked back to the financial advisor. Vanguard markets itself through fee-based financial advisors or directly to the individual investor either through the phone or over the Internet. Vanguard is really taking advantage of the information age where people can price-compare and buy the lowest-cost fund, which as we've known, as [Morningstar director of fund research] Russ Kinnel and yourself have studied the lower the cost of the fund, usually the better your experience as an investor.

Benz: Now, Vanguard historically had not really catered to that advisor segment, but does it seem like they are putting greater efforts behind that?

Rawson: Absolutely, especially with the advent of ETFs. In fact, just the other day Vanguard filed for active ETFs, which is interesting because you wouldn't expect Vanguard to be on the forefront of active ETFs. I think the whole reason why they're doing this, and this is speculative on my part, I haven't talked to them, but I think the reason why they're doing this is to go after financial advisors.

Financial advisors typically could only buy a mutual fund which is on their "platform." They have some kind of distribution agreement with the fund companies and say, "If we sell your fund, you've got to give us a slice of that money." Well, that's not the case with ETFs. You go right to the stock exchange and buy it, and the fund company never has to even really get involved. I think the reason why they're doing active ETFs is so that financial advisors could buy some of Vanguard funds, even though they were maybe in the past prohibited from buying Vanguard mutual funds. In my mind, there's really no other reason to explain it. It's not a cost issue for Vanguard because Vanguard's mutual funds and ETFs are really identical, so one's not necessarily cheaper to run than the other. They really don't care what you buy. So, I think the whole reason for them to launch this is to go after those financial advisors.

Benz: Interesting insights. Mike, thank you so much for being here.

Rawson: Thanks for having me, Christine.

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