Flows Still Point to a Near Record Year for Fixed Income

Optimism and positive performance in the third quarter gave way once again to the realities of markets and economies that continue to be fraught with risk and uncertainty. As if concerns about slowing growth in both developed and developing economies, the European debt crisis, and the upcoming U.S. elections and pending fiscal cliff weren't enough, the wide swath of destruction caused by Hurricane Sandy, which shut down trading on Wall Street for two full days, left investors once again pursuing the relative safety of bonds. The decline in the S&P 500 TR Index last month had less of an impact on flows for actively managed U.S. stock funds than we anticipated, but was still the fourth-largest monthly outflow recorded this year. With investors continuing to favor fixed income over just about every other asset class, flows into actively managed taxable bond funds have surpassed the level of inflows seen in all of 2010 and could reach the record level seen during 2009. We continue to believe that the more broadly diversified asset managers, especially those that offer a mix of active and passive strategies, strong equity and fixed-income franchises, and exposure to both domestic and international markets, are best positioned in this environment.

No Relief From Net Redemptions From Actively Managed U.S. Stock Funds
The decline in the S&P 500 TR Index last month had less of an impact on flows for actively managed U.S. stock funds than we anticipated, but with more than $32 billion pulled out of the broad asset class during August and September (when the market was actually going up), we think investors were looking to avoid the next downturn in the markets, taking advantage of the runup in stock prices overall to take some cash off the table before the end of the third quarter. The nearly $12 billion in outflows that hit actively managed U.S. stock funds during October were the fourth-largest monthly outflows recorded this year, with the category (at more than $97 billion in net redemptions through the first 10 months of 2012) on pace to surpass the level of outflows seen not only in 2011, but during 2008 as well. As we noted last month, we think this has far more to do with the performance of active managers than it does the direction of the markets. According to Morningstar's index data, domestic stock funds as a whole (which includes large-, mid- and small-cap funds dedicated to growth, blend, and value strategies) were underperforming the benchmark S&P 500 TR Index by around 150 basis points through the first three quarter of 2012, with no single category outperforming the S&P 500 TR Index at the end of the third quarter. This was also the case last year, with domestic stock funds overall trailing the benchmark index by around 250 basis points through the first nine months of 2011, so it is no real surprise to see this year's outflows from actively managed U.S. stock funds tracking the results that were reported last year. While we should acknowledge the impact that American Funds is having on the overall tally, especially in a category like large-cap growth, where American Funds Growth Fund of America has reported more than $28 billion in outflows year to date, compared with the nearly $30 billion in net redemptions reported for the large-cap growth segment overall, we have seen the outflows from American Funds diminish over time, leading us to believe that investor dissatisfaction is now on the rise in other parts of the actively managed U.S. stock fund category; this is not too surprising, given the underperformance that has been seen overall for the category over the past two years.

U.S. Stock Index Fund Flows Turn Positive, While ETFs Go Into Net Redemption Mode
While flows for actively managed U.S. stock funds were once again negative during October, index funds had a decent month, with flows into Vanguard Total Stock Market Index accounting for more than half of the $4 billion that flowed into the category last month. While its counterpart in the ETF market--Vanguard Total Stock Market ETF--saw positive flows as well, the category itself went into net redemption mode, as outflows from State Street's SPDR S&P 500 contributed more than two thirds of the $11 billion in outflows that were seen during October. As this fund tends to be heavily influenced by movements in the Volatility Index produced by Chicago Board Options Exchange, seeing bigger movements in month-to-month flow data in periods of greater market volatility (much like we saw during the weeks leading up to the U.S. elections this month), we're not too surprised to see the category dip into net redemption mode. The mood did little to damp Vanguard's monthly flows, which have averaged around $1.2 billion per month this year (and $1.1 billion over the past two years) allowing the firm to continue to capture share at the expense of its peers. It should be noted, though, that BlackRock has made some strides with its efforts to combat some of its share losses, much of which has been driven by lower fees structures on core U.S. equity products offered by Vanguard and others in the retail channel. BlackRock's decision to cut fees on six of its larger, more liquid core asset class ETFs, which is where iShares has been hit the hardest, and offer four new long-term ETFs with lower fees seems to be working, with this core series of iShares ETFs garnering $2 billion in inflows since their launch last month. With BlackRock also integrating its own U.S. retail salesforce with iShares sales team, while at the same time initiating a global brand push and marketing effort behind its ETF offerings, the firm should be able to maintain its market-leading position in the category.

Sector Stock Fund Flows Cool as Investors Walk Away From Real Estate and Utilities
Looking at the sector stock category, which includes such heavy hitters as Vanguard REIT Index Fund, Vanguard Health Care, and Vanguard Energy, as well as their counterparts in the ETF market, investors pulled back dramatically during October. While real estate funds continued to see positive flows during the month, the run rate was well off what was seen in the category over much of the past year. Utility funds also remained in net redemption mode, no doubt over concerns that the Bush-era tax cuts would be allowed to expire at the end of this year if President Obama was elected to a second term. For those not familiar with the specifics, current law taxes both dividends and long-term capital gains at a maximum federal rate of 15%, which has been the case since 2003. Assuming nothing changes, dividends will be taxed as ordinary income (up to 39.6%) starting in 2013, with long-term capital gains taxed at half the ordinary rate (up to 19.8%). A new health-care-related tax on investment income for high earners will tack on another 3.8 percentage points to both rates next year, which helps explain why some investors have soured on both the real estate and utilities sectors, which have traditionally offered some of the best yields among different stock sectors.

International Stock Fund Flows Improve, With Actively Managed Funds Seeing Biggest Improvement
Excluding the impact of American Funds, flows for actively managed international stocks funds moved back into positive territory last month, after spending most of the third quarter in net redemption mode. We continue to be dumbfounded a bit by last quarter's action, given that the international stock category overall was performing better than all three benchmark indexes--the MSCI World Ex US NR, MSCI EAFE NR, and MSCI EM PR--through the first nine months of 2012. But much as we saw with U.S. stock funds, it looks like investors were looking to avoid the next downturn in the markets before it actually happened. American Funds Capital World Growth & Income continues to have the biggest impact on flows for actively managed international stock funds, with the fund losing another $1.4 billion to net redemptions during the month of October. While the picture might be a bit muddled on the actively managed side of the business, flows for international stock index funds and ETFs continued to be strong. Diversified emerging market funds continue to be the biggest drawer of investor attention--seeing close to $25 billion in investor inflows so far this year--with the Vanguard Emerging Markets Stock Index fund, and its corresponding ETF, continuing to generate the lion's share of the inflows (at close to $12 billion year to date). That said, the announcement from Vanguard early last month that it was switching 22 of its biggest index funds away from benchmarks provided by MSCI as part of its effort to lower costs is having an adverse affect on flows for funds like Vanguard MSCI Emerging Markets ETF because of the replacement benchmark's significant difference from the MSCI index. This is turning out to be a short-term boon for BlackRock's iShares MSCI Emerging Markets Index and the recently launched iShares Core MSCI Emerging Markets Index Fund, which saw more than $1 billion in positive flows last month and continue to attract the attention of institutional investors that have their international equity exposures benchmarked against MSCI indexes and would need the approval of their boards to adjust their investment mandates.

Investor Flows Into Taxable Bond Funds Edge Even Closer to Record Territory
With investors continuing to favor fixed income over just about every other asset class, flows into actively managed taxable bond funds (at $199 billion through the first 10 months of 2012) have now surpassed the level of inflows seen in all of 2010 ($192 billion) and could reach the record level of inflows seen during 2009 ($255 billion) if flows in November and December exceed the $27 billion seen during October. Even if flows stay closer to the $20 billion monthly run rate seen so far this year, the category would close out the year with $239 billion in total inflows. Adding in the flows for passively managed products brings the total flows for taxable fixed income this year to $271 billion, well beyond the $247 billion that flowed into the broad asset class overall in 2010 and likely to surpass the $330 billion that flowed into the category overall in 2009. Inflows into intermediate-term bond funds continue to dominate the flows going into both actively managed and passively managed taxable bond funds, with high-yield bond funds and short-term bonds funds continuing to battle for that more distant second-place spot. It is also interesting to see flows into municipal bond funds remaining relatively robust, considering how much of a pariah they were during the first three quarters of last year. This could, however, be the result of some investors rotating into tax-free investments in anticipation of increased taxes after the elections this year.