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Indexing Gains Ground, but Not Everywhere

Christine Benz
Timothy Strauts

Christine Benz: Hi, I'm Christine Benz for

Amid a volatile equity market, investors pulled assets from U.S. stock funds in July. Joining me to discuss the latest fund flow data is Tim Strauts, a senior analyst with Morningstar.

Tim, thank you so much for being here.

Tim Strauts: I'm glad to be here.

Benz: Tim, when you look at the headline numbers for U.S. equity mutual funds, we actually saw larger-than-typical outflows in the month of July. The markets were volatile. Do you think it's simply that investors were feeling a little bit spooked?

Strauts: U.S equity funds saw a little over $11 billion in outflows in July, which is an accelerating pace over the last three months. Now, obviously, negative returns affect that, but I think it's also a thought that's been present in the media that the U.S. market may be a little overvalued. It may have gone up so fast over the last 18 months that it may be time for a cool down in the U.S. market.

Benz: Time to take some profits. I have been advising investors to rebalance.

When you add back in what's been going on in exchange-traded funds--we were talking about just mutual funds before--when you add ETF flows in, how does the picture look for domestic equity?

Strauts: The picture changes dramatically when you look at ETFs. Just in July the negative $11 billion outflow turns into only a negative $1.7 billion outflow when you factor in ETFs.

And on a year-to-date basis, U.S. equity mutual funds had a negative $4 billion total outflow, but when you add ETFs in, it turns into an $8 billion inflow. There is definitely a trend here. Maybe investors are moving from their mutual funds to ETFs.

Benz: And even among investors who are sticking with traditional mutual funds, we are also seeing them swap from active products into index-type mutual funds.

Do you see anything reversing this trend? We've been monitoring it for a few years. Or do you think that investors will continue to make this switch?

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Strauts: In short, I don't think there is really much that's going to change it. The trend has actually happened since 2005, where U.S. equity active funds have been in net redemptions consistently every year since 2005, and passive equity funds have had strong inflows.

So investor sentiment has changed and the pattern of how we invest in U.S. equity funds has gone to an index-based nature.

Benz: It looks a little different, though, curiously when you look at international equity funds. The traditional international funds are seeing pretty decent inflows--they did in July as well as year-to-date--and there it seems that investors in fact are choosing actively managed products. What's going on there?

Strauts: Year-to-date, active international funds have taken in $51 billion in new flows, and passive funds have taken in $22 billion. There is definitely a clear preference for active management with international funds. I think that's due to a mindset that there is more opportunity for active management to pay off when you have a much larger set of stocks you can buy in the whole international market.

Now, conversely, we actually haven't seen it through the data that active international funds have done that much better than their passively managed counterparts. But investors seem to think that makes the most sense right now.

Benz: They think it's still a place where it's worth paying up for an active manager.

Let's take a look at bond funds. While we did see outflows from domestic-equity funds, bond funds did see some pretty good inflows during the month of July.

Let's talk about the types of funds that investors are buying. We saw this strong rally in longer-duration bond-fund types, but investors really aren't putting their money there, right?

Strauts: No, investors have never really put too much money in long-duration bond funds. We actually did a study a few months ago that showed only 5% of fixed-income mutual fund assets are invested in funds with a duration greater than eight years. So basically, no one buys a fund that has a duration greater than eight years, mainly because they are very volatile. They actually have volatility in some cases that is higher than stocks, and with these ultra-low interest rates, at some point--we don't know when that's going to be--these funds will actually be some of the worst-performing funds out there as interest rates rise.

Benz: And yet, performance has been pretty good, at least recently?

Strauts: Recently.

Other things to note in the bond categories: We some outflows out of bank loan and high yield, and inflows into intermediate-term bond. So, investors seem to be shying away from the credit-sensitive areas of the market and looking more toward the safer intermediate-term bond category.

Benz: Within intermediate-term bond, one story we've been watching relative to flows is PIMCO Total Return. Are you seeing outflows abate at that fund? It's really taken outflows pretty hard so far this year.

Strauts: It still had an outflow in July of $830 million, but that's a big improvement. Over the last 12 months, it actually had an average outflow of $4.4 billion. So, outflows have started to taper off. They haven't turned positive by any means yet, but we'll have to wait and see what happens in the future.

Benz: Tim, thank you so much for being here.

Strauts: Glad to be here.

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