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Penchant for Passive Continues in 2014

Christine Benz
Timothy Strauts

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Following Bill Gross' departure from PIMCO in September, assets leaving PIMCO Total Return (PTTRX) appear to be finally slowing down. Joining me to discuss this and other news in realm of asset inflows and outflows is Tim Strauts. He's a senior markets research analyst for Morningstar. Tim, thank you so much for being here.

Tim Strauts: Thanks for having me.

Benz: Tim, I know that you and the team have been monitoring the situation at PIMCO Total Return. We've really been looking at it to see whether it will affect our view on the fund. You've been looking at whether redemptions are affecting the fund's positioning. Let's talk about the fact that redemptions from PIMCO Total Return do appear to have slowed down a bit.

Strauts: Well, for one, PIMCO Total Return actually had a very good month last month. They were up a little over 1%, which was good [enough to place the fund in the] top one percentile for the category, so that sure has helped. But they did lose $9.7 billion in assets in the fund, which is an incredible amount but much smaller than the $32 billion they lost last month. So, flows seem to be getting better. But over the last three months, they have lost over $60 billion in just that fund. As a firm, PIMCO is also shedding assets besides Total Return. Last month, the firm lost $12.8 billion. And over the last three months, they have lost close to $89 billion.

Benz: Let's look at where those assets are going. First, are they going to Bill Gross' new charge at Janus?

Strauts: Well, Bill Gross had a good month for flows but not in comparison to the PIMCO flows. They got about $800 million in new assets into his Unconstrained Bond Fund (JUCIX) at Janus, which is very good. But considering that almost $10 billion left Total Return, he is obviously not the main beneficiary of the new assets.

Benz: So, let's talk about which funds have been the biggest winners as Gross has departed PIMCO Total Return. Where are investors putting their money if they are pulling it from Total Return?

Strauts: Two funds we are seeing get the most flows are Metropolitan West Total Return Bond (MWTIX) and Dodge & Cox Income (DODIX) on the active side. And it wasn't as much this month, but we have seen Vanguard Total Bond Market (VBMFX) on the passive side also get a lot of the flows.

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Benz: I want to follow up with you on passive versus active; I know that this is a trend that we've been monitoring, certainly when we look at the equity fund flows. Where do investors stand on active versus passive when it comes to their fixed-income stakes? Are you seeing the same trend toward passive products on the fixed-income side?

Strauts: We definitely are seeing flows toward passive funds on the fixed-income side, but it's not as strong as we see in the equity space. In the bond space, some of the big active managers are still able to show outperformance. And that is partly because they have a little bit easier of a time [as a result of] the over-the-counter nature of the bond market, where trading is much less efficient than it is in equities. So, they have more opportunity to add value. So, we're still seeing investors allocate to active funds, but there still is obviously a lot of money still flowing toward the passive side.

Benz: I want to follow up on a couple of niche fixed-income categories, where you think that the fund-flow data are notable. One is high yield: We've seen a little bit of a performance hiccup for high-yield bonds; spreads have widened a little bit here in the past couple of months. Let's talk about what investors are doing with that high-yield category.

Strauts: High yield has actually sold off for the last three months--primarily because the index was loaded up with energy bonds and obviously oil has plummeted over the last several months. So, that has really damaged the values of some of these energy bonds. So, high yield is really taking it on a chin.

We've seen high yield sell off by about 5% to 7%, depending on what funds you are in. And the flows have been negative. But actually, this month, high yield actually had positive flows. It was one of the highest-flowing categories with over $3.5 billion in new assets. So, high yield has actually done pretty well this last month.

Benz: That's not something we usually see where performance is not so good, but investors appear to be adding assets. Any conjectures about why this might be?

Strauts: It's really hard to say--because it is surprising, considering all of the negative news that's out there about oil continuing to go lower, that investors are willing to jump back into high yield. But what's also interesting is that the bank-loan category, which is essentially high-yield bonds but with floating rates, was one of the worst-flowing categories with over $1 billion in losses last month. So, I think there's a weird dichotomy between the high yield being in positive flows and the bank loans being negative.

Benz: Bank loans, not so long ago, were by far the biggest asset-gathering category. So, this has been kind of a turnabout. Do you think it's just that yields aren't that good relative to competing alternatives, or why have investors gone sour on the bank-loan group?

Strauts: Well, one thing is that I think the bank-loan investor is a different investor than the one who buys high yield--because bank loans are marketed to investors by fund companies as a way to hedge against rising rates. They were short-term securities with interest rates that adjusted on a regular basis. So, whenever interest rates rose, they were going to take advantage of it with bank loans.

Well, the opposite has happened. This year, yields have actually fallen and, as we said, high-yield bonds have actually sold off. So, there is a double whammy for the funds. So, the investors who bought the funds were not expecting this, and they're kind of running for the door.

Benz: Let's switch gears and talk about equity fund flows. It seems that when you look at the year to date--and we're almost through 2014--that this passive-products juggernaut continues. We continue to see very strong flows into passive equity funds of all stripes, correct?

Strauts: It's been the year of passive U.S. equity. Just over the last 12 months, there has been $156 billion that has gone into passive U.S. equity funds. But $91 billion has left active U.S. equity funds. So, a good portion of the money is just moving from one side to the other--selling their active U.S. equity and buying the passive. And that trend continued last month with $26.6 billion in passive U.S. equity flows and a negative $11 billion in active flows. So, it seems clear that investors just aren't willing to pay the higher fees for U.S. equity investments.

Benz: And some of that trend appears to be driven by advisors, correct? More advisors are kind of switching their business models to focus more on the passively managed products.

Strauts: Yes. Especially as we move to a more fiduciary standard with fee-based accounts, advisors definitely are choosing more of the index products.

Benz: How about international equity? Do you see a strong preference for passive products there as well?

Strauts: Traditionally, we haven't seen it as strongly in the international space because there is this idea that active managers have a better opportunity to outperform in the international space. But last month, the flows were very strongly toward passive--$12.5 billion to passive international and only a $100 million inflow into active international. So, this month, we saw very strong passive flows.

Benz: You've noted, though, that there is one category, or one group of funds, that appears to be bucking this trend--where investors, in fact, appear to be preferring active products. Let's talk about that group of funds.

Strauts: It's the allocation category. And actually, over the last year, there has been $46.5 billion in inflows into active allocation funds but only about $4 billion into passive. So, it's kind of interesting because we see passive winning in every other category. But in allocation, it seems that investors are more comfortable letting active managers pick the combination of stocks and bonds than they are letting investors pick the individual securities.

Benz: Tim, thank you so much for being here to share your insights. It's always great to explore this intersection between investor behavior and fund performance. Thank you.

Strauts: Thanks for having me.

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