Rising Stock Markets a Bigger Positive for Passive Equity Flows

The ongoing rally in the U.S. equity markets (with the S&P 500 TR Index up 16.7% since the start of the year) has done nothing to persuade investors to put more capital into actively managed U.S. equity funds, according to the most recent fund flow data provided by Morningstar Direct. Much as we've seen the past five years, the majority of the capital that has been going into equities is being directed at passively managed products--index funds and exchange-traded funds--which have become the default option for investors looking to gain exposure to equities. While there was some thought that fixed-income flows would falter this year, the data through the first three weeks of May would indicate that investors have not thrown in the towel on the category, with flows for taxable fixed-income products tracking the quarterly run rate that has been in place since the financial crisis.

Outflows Continue for Actively Managed U.S. Equity Funds
Even as the U.S. equity markets gained more ground in the second quarter (with the S&P 500 TR Index up more than 5% since the end of March), investors have reverted to shunning actively managed U.S. equity funds, with January just a blip in what has been a six-year trend of outflows from the category. Flows have been positive for actively managed U.S. equity funds in just 13 out of 72 months, with more than half of those positive flow periods occurring during the first two months of the calendar year. This means that absent the portfolio rebalancing and retirement funding that typically takes place in the first quarter of any given year, the flow picture would be even more dire for managers of actively managed U.S. stock funds.

With investors being extremely selective about where they put money to work in actively managed funds, we've expected the managers that cater more directly to this category to struggle with flows, especially if the performance of their U.S. equity funds has trailed their benchmark or category, or if they lacked effective distribution. So far, this has played out as we expected, with Janus Capital, which has been challenged both with its investment performance and its move to third-party distribution, reporting $1.1 billion in outflows from its domestic fundamental equity operations during the first quarter.

Compare this with T. Rowe Price, which has had a long record of solid fund performance and actually pulled in $5.2 billion with its domestic equity and balanced fund offerings during the first quarter. While some of this can be attributed to the fact that the firm sources a significant portion of its managed assets from retirement accounts and variable-annuity portfolios, T. Rowe Price has consistently generated positive flows with its equity and balanced offerings in most calendar quarters.

ETFs and Index Funds Default Option for U.S. Equity Investors
Even after backing out the impact of State Street's SPDR S&P 500 fund, which tends to be used more heavily by traders as a hedge for their own market exposure, flows into ETFs dedicated to U.S. equities have been stronger in May than in April, with more than $15.0 billion flowing into the category since the start of the second quarter. If this trend continues through the end of June, the second quarter will become the fourth straight quarter of inflows of this magnitude into U.S. equity ETFs, which is something that has never happened before.

There is still plenty of growth left in the ETF market. While the U.S. ETF market overall (which includes all asset classes) is unlikely to continue its 29.5% compound annual growth rate of the past decade, we believe it has the potential for a 15.0% CAGR (including both organic growth and market appreciation) over the next five years. We expect much of this to be front-end loaded, though, with ETF growth this year likely to match the 27.0% rate experienced during 2012 and growth in the final years of our forecast averaging about 10.0% per year. At that rate, there should be more than $2.7 trillion invested in domestic ETFs overall at the end of 2017, compared with the $1.3 trillion that was invested in these funds at the end of last year.

Sector Equity Funds Fall Off Their Record Pace
After hitting $26.2 billion during the first quarter, flows into sector equity funds have fallen off some during April and May, with total flows for the second quarter likely to end up around $20.0 billion. That said, the period is still likely to rank among the top five for quarterly inflows into sector equity funds overall, which includes actively managed funds, index funds, and ETFs, with the first quarter of 2000 being the largest on record (at $34.7 billion) and the first quarter of 2011 being third (at $19.4 billion). It should come as no surprise, though, that the top three quarterly flows actually occurred during the first quarter, given the amount of asset reallocation that typically takes place during the first part of any calendar year, with sector funds offering an easier option for investors looking to gain exposure to particular market sectors, but not wanting to select individual securities.

We would, however, note that ETFs were barely a blip on the radar in 2000, but accounted for 60% of the inflows during the first quarter of 2013 (and made up more than 50% of the flows that came in during the first quarter of 2011). Second, the lion's share (76%) of the inflows for sector stock funds that were recorded during the first quarter of 2000 were chasing technology stocks, whereas the largest flow generator this year has been funds dedicated to domestic real estate (27%), with health care (14%) and domestic energy (14%) distant second and third generators of flows (not too dissimilar from what we saw in 2011).

International Equity Fund Flows Taper Off During Second Quarter
After fully embracing international equity funds during the first quarter, with the $64.8 billion that flowed into the category during the period bested only by the $69.3 billion that flowed into active and passive international equity funds combined during the first quarter of 2006, investors have cooled their interest in these funds during the second quarter. Around $24.1 billion has flowed into these funds since the start of the second quarter, leaving the category on pace to generate at least $30.0 billion in total inflows, well above the average quarterly run rate of $20.9 billion over the past 10 years (and $12.1 billion over the past five years).

While actively managed international equity funds had bucked the trend of passively managed international equity fund flows, trumping those for actively managed funds in April (much as they had during the first quarter), flows swung back toward passively managed products in May. Much like U.S. equity funds, international equity funds have seen a major shift in flows toward passive strategies over the years. While the shift did take longer to materialize, with flows into passively managed international equity funds only starting to outpace those for active funds during 2008, and while there might be some periods where flows into actively managed funds outpace those for passively managed products, the trend of passive trumping active continues.

Allocation Funds Continue to See Solid Investor Interest
Between the financial crisis, which left many investors looking for more balanced approaches to their investment portfolios, and changes in defined contribution plans--including the institution of auto-enrollment, re-enrollment, and qualified default investment alternatives--which have contributed to the growth of life-cycle and target-date retirement funds, quarterly inflows for allocation funds have been a key source of organic growth for many asset managers. The category itself has grown from $293.2 billion in total assets under management at the end of the first quarter of 2003 to $942.0 billion at the end of the first quarter of 2013, reflective of a 12% CAGR over the past decade. While not quite as impressive as the growth rate seen for U.S.-based ETFs (of around 29.5%) during the same time frame, allocation funds have been one of the better growth areas for the industry since the equity markets bottomed out in early 2009.

Unlike other asset classes, the allocation fund category is one where active management has not been upended by the growth of passive investment options. Actively managed allocation funds accounted for more than 95% of the total category at the end of the first quarter and continue to capture the lion's share of investor inflows. This is also one area of the market where Vanguard, known more for its low-cost index funds and ETFs, is actually a major player, with its $107 billion in actively managed balanced funds (and $20 billion in passively managed offerings) at the end of the first quarter being second only to American Funds, which had $227 billion under management (primarily on the active side of the business) at the end of the period. Looking more closely at the flows in April and May, though, it does appear that investors have pared back their interest in the category, with total flows for the second quarter of this year likely to look more like the first quarter of 2012 than the first quarter of 2013.

Fixed income Continues to Garner Interest From Investors
Flows into taxable bond funds of $76.7 billion overall during the first quarter were a fairly strong sign that investors had not thrown in the towel on the category. While not the largest quarterly flows since the financial crisis, being the eighth largest since the start of 2009, it was well above the quarterly run rate for taxable bond fund flows of $67.8 billion for the period--hardly a sign that investors are walking away from fixed income in favor of equities. Based on the weekly flows we've seen through the first three weeks of May, it looks as if taxable bond fund flows are going to end up at something close to that run rate (with our estimates putting total flows at just over $67.0 billion) during the second quarter. That said, there has been some shift in where investors are putting money, with bank loan funds capturing most of the inflows the past couple of months. While intermediate-term bond and short-term bond funds continue to generate flows, they're well off the monthly pace that was seen during 2012, and investors continue to pull capital out of intermediate government bond and inflation-protected bond funds. Municipal bond funds have not had it much better, with the outflows recorded during April severely limiting the category's ability to match the average quarterly run rate for inflows of $10.6 billion in place since the end of the second quarter of 2011.

Net Redemptions of Gold Funds Affect Flows for Alternative and Commodities Funds
While gold prices really didn't start to fall off a cliff until the second week of April, investors started pulling out of gold ETFs in February and March (with that trend continuing well into April and May), taking the entire commodities category--which includes funds dedicated to agricultural products, basic materials, precious metals, and energy--down as a result. The only real winner this year has been actively managed commodities broad basket funds, which invest in a diversified basket of commodity goods and saw $3.5 billion in total inflows during the first quarter and have reported more than $500 million in inflows since the start of the second quarter. However, this pales in comparison with the flows that have been reported for the alternatives category--comprising funds dedicated to currencies, futures, and myriad trading strategies--which is already on pace to surpass the record $11.7 billion that flowed into the category during the first quarter.