Fed Action Keeping Bond Funds Popular

Christine Benz: Hi, I'm Christine Benz for Morningstar. Since late 2008, assets in bond funds have jumped up by nearly $1 trillion and there is no end in sight. Joining me to discuss the latest trends in mutual fund inflows and outflows is Kevin McDevitt. He is a senior analyst with Morningstar. Kevin, thank you so much for being here.

Kevin McDevitt: Thanks for having me, Christine.

Benz: Kevin, this trend toward investors buying bond funds continues unabated. The Federal Reserve has kept rates down at zero, so what are investors responding to because the yields certainly aren't there for bonds?

McDevitt: As we've talked about for a while now, just you've had this long migration out of money market funds into taxable-bond funds for the most part, although municipal bonds to some extent, too, which we can talk about. But it seems to be this bifurcation in terms of where investors are going. It seems like about half the flows roughly tend to go more in the core areas of taxable bonds, the taxable-bond categories like intermediate-term and short-term. But then--and especially of late--you've seen a kind of resurgence of demand for more credit-oriented categories, things like high-yield bonds, emerging-markets bonds, multisector bond funds, and even bank-loan funds, which had been popular you may recall last year. They kind of declined in their popularity, but now the demand seems to be increasing again for bank-loan funds. As you alluded to at the beginning, I think a lot of this goes back to what's happening with the Fed, what's happening with central banks. The Fed of course announcing Sept. 13, they are going to continue with Operation Twist. They will continue to buy bonds as part of that program. So, in essence it's going to continue to facilitate greater flows into bond funds. It's hard to see what would really change this demand picture unless there is something like an unexpected spike in inflation or an unexpected spike in rates.

Benz: So, you are saying that even though yields on bonds aren't all that great, especially in high-quality land, they are better than the zero what that most investors are earning on their cash right now.

McDevitt: Yes, absolutely. I think that goes back to, it seems like investors are looking for one of two things. I think if you're more inclined to go for like a short- or intermediate-term bond fund, it's perhaps a bit more about capital preservation. You want it to do a bit better than you would do in a money market fund versus if an investor who is going more into the credit-oriented categories; it's more about yield-seeking in those cases. So again, you're seeing strong demand on both sides. I imagine perhaps there are different groups of investors for those types of funds.

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Benz: So, one thing we've been talking about in the equity-fund world, Kevin, is this trend toward investors embracing passive products. They've been buying index mutual funds; they've been buying a lot of exchange-traded funds. The question is have you seen that carry over into the fixed-income space? What are investors doing in terms of selecting actively managed products or index products?

McDevitt: That's a great question. You know, we had not really seen the same kinds of patterns with taxable-bond funds we had on the equities side in terms of passively managed funds. About two or three years ago, even though you had strong flows going into bond funds, it would for the most part, much more going into actively managed products than passively managed funds.

Actively managed funds were really dominating, and they still are for the most part. But I think, what's changed over the last 12 months is you're seeing much stronger flows into passively managed bond funds. So that is a bit of a change. In terms of, just looking at the past 12 months, the passive market share of new inflows [into fixed income] is about a third, which is quite high. This isn't a one-for-one comparison, but it makes for an interesting comparison, at least when you look at the passive share of assets on the equities side. If you look at U.S.-stock funds, passively managed funds now represent about one third of all assets. So, it's interesting to see that you see the same level or same degree of market share for passively managed fixed-income funds on the taxable-bond side.

Benz: You mentioned equity funds. Kevin, August was another weak month in terms of flows, even though the equity market was relatively good during the month. You noted that actually there were outflows not just from actively managed funds and traditional mutual funds, but equity ETFs didn't have such a great month in terms of flows either?

McDevitt: Yes, that was the real surprise. Seeing the outflows out of domestic-stock ETF funds was a real surprise. And as you said that really hasn't been the pattern; the pattern has been more, you've seen flows out of actively managed U.S.-stock funds and into passively managed U.S.-stock ETFs. This past month in August that did not happen. You saw outflows out of U.S.-stock ETFs of about $8 billion or so, and that's on top of the $14 billion or so that left open-end U.S. stock funds.

So you had about $22 million, $23 billion or so in outflows out of U.S.-stock funds and that really makes it one of the worst months we've seen in the past five years. It was really kind of a staggering number. Given that as you said, it wasn't a bad month in general for equity funds.

Benz: So it's hard to know what investors as a group are thinking there. Obviously there are some concerns about the fiscal cliff and so forth, but market performance was actually pretty good. Kevin, were there any bright spots during the period? Any equity fund types that did see inflows?

McDevitt: Not really. I almost could give you a flat "no." But the only group--and this goes across both U.S.- and foreign-stock categories--the only group that really saw any decent inflows was diversified emerging markets, and even in that category demand has been falling. Diversified emerging-markets funds took in about $1.3 billion, $1.4 billion in August, and that's well down from the demand we've seen over the last three years on average. The typical month for the past three years has seen about $2 billion in inflows for diversified emerging-markets funds, but again, even this past month saw a real decline in demand. And you look at other international categories and look at other U.S.-stock categories, and really across the board you saw perhaps tepid inflows, but in general, you saw outflows across the board.

Benz: Kevin, let's take a look at the fund-family view. We have some familiar stories here with Vanguard, PIMCO, and DoubleLine continuing to have very good years in terms of their organic growth rates and in terms of new inflows. Another firm though jumped into the top 10 in terms of new assets, and that's Old Westbury. Let's talk about that firm, what its product lineup is like, and what investors are buying from that firm?

McDevitt: Old Westbury is maybe not a familiar name, but they use a lot of familiar names as their subadvisors. The fund that really kind of carried them into the top 10--among the top 10 families in terms of flows last month--was their Global Opportunities fund, which is a world-allocation fund. And again, the Old Westbury name might not be familiar. But on that fund it's a group of subadvisors, and one of the subadvisors, for example, is Michael Hasenstab, the fixed-income manager from Franklin Templeton who is well-known for his work on Templeton Global Bond and Templeton Global Total Return. And then the BlackRock fixed-income team also manages a sleeve of that fund. So, Old Westbury is really using a subadvisor strategy and using in some cases some really well-known, well respected advisors. Perhaps that helps to explain some of the demand interest in their funds.

Benz: Well, Kevin, thank you so much. It's always great to hear about the intersection between investor psychology and buying behavior. Thank you for being here.

McDevitt: Thank you, Christine.

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