Investors Still Exiting Bonds

Jason Stipp: I'm Jason Stipp for Morningstar. Morningstar's August asset-flows data showed investors continuing to pull money from fixed-income funds and putting money into equity and other categories. But as usual, there's more to the story than that. Here to offer the details is Mike Rawson, a fund analyst with Morningstar.

Thanks for being here, Mike.

Michael Rawson: Pleasure to be here.

Stipp: Fixed income continued to lose assets. This is the continuation of a trend that we've seen since the spring.

Rawson: Yes. In May and June we saw interest rates spike, but interest rates have continued to tick up a bit even through as recently the end of August and are flirting with that 3% level on the 10-year Treasury bonds. We've seen strong outflows from fixed income, whether it'd be taxable bond or municipal bond, and that's continued all summer.

Stipp: Of course, before we saw this interest-rate spike, fixed income had gotten a lot of assets. They're nowhere near losing all the assets that they've gained over the last several years.

Rawson: Sure. People were talking about fixed income being in a bubble, with tremendous inflows in 2012. However, there has been a pretty sharp reversal. In fact, Bill Gross' total-return fund, PIMCO Total Return, was one of the largest accumulating funds in 2012. Well, he's lost all of that. [There has been a decline of] about $40 billion in assets since the end of May. About $26 billion of that is from outflows, $15 billion of that is from a negative return on the fund. It's really phenomenal that last year it was one of the biggest accumulating funds, and he's lost it all just within a matter of few months.

Stipp: Our data also show that international- and domestic-equity funds gained inflows and a lot of other categories did, as well. We had, except for bonds for the most part, a lot of inflows into other areas?

Rawson: Yes. Taxable bond and municipal bond, again, had strong outflows. This has been going on now for several months where we've had outflows from municipal bonds. I think not only because of the rise in interest rates, but still that Detroit story is hanging over municipal bonds. But the other category groups, such as you mentioned U.S. equity, international equity, alternatives, and commodities, those are seeing inflows. So investors are going to other places.

For example, one of the funds in the equity category that was leading in terms of the amount of fund flows was Vanguard Total Stock Market Index. That's one of my favorite funds just because it's so low-cost. You get exposure to the entire U.S. market, even down to micro-cap stocks for a really low expense ratio. That fund is gaining assets. So the money is going to other places [other than bonds].

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Stipp: Even though fixed income broadly lost money, not every category in fixed income lost money. We did see inflows into a couple of notable categories, one of them being bank loan.

Rawson: Bank loan, again, continues to be really popular. That category is a small category, only about $120 billion in assets, but it's virtually doubled within a year. People say, "Why bank loans?" Well, it's that perfect solution to the problem of the Fed raising interest rates or at least beginning to taper. If the Fed does taper, obviously, that's going to cause interest rates to go up.

Bank loans have a very short duration [a measure of interest-rate sensitivity] because they're floating-rate, so their interest rates will be set. Thus, they're immune to that interest-rate risk. Also there is some credit risk there, but when the Fed raises interest rates, they're probably going to do it because the economy is strengthening. So bank loans should do well in an environment where the economy is doing well.

Stipp: Definitely now that you're taking on more credit risk, but generally in an environment where rates are rising, we would expect to see fewer defaults overall.

Rawson: Yes.

Stipp: Another category in fixed income that did see inflows was the ultra-short-term bond-fund category, and I'm assuming this is because, again, that short duration really shields you from rising interest rates.

Rawson: Yes. Again, I think this is an issue of investors don't know where to go. Fixed-income investors, obviously, they want the safety of fixed income, but they're not going get that if interest rates are going up. So they're going to these ultra-short-term bond categories. It's similar to a money market category, maybe a little bit more yield, but really at these levels you're just putting your money into a cashlike instrument where you're just waiting for better opportunities. Maybe these are people that are hesitant to go into the equity markets because they view the equity markets as expensive, but they don't want to be in long-term bonds certainly. Instead, they're going to a very close-to-cash type of investment.

Stipp: What about this newer category called nontraditional bond? They're seeing inflows there, as well.

Rawson: We've talked a lot about PIMCO Unconstrained in that nontraditional bond category getting a lot of flows last month. We saw JPMorgan Strategic Opportunities, which is a nontraditional fund, get a lot of flows. This is a category where the manager has some leeway in terms of the interest-rate exposure or the credit exposure that they might take.

Now, we read PIMCO's Bill Gross’ views. We know that he wants to invest outside of his benchmark, but really he is somewhat constrained just by the size of his fund. Generally, at the end of the day it's going to be a core-type of bond fund. He doesn't want to stray too much from that mandate. But these other funds, like PIMCO Unconstrained, have the leeway to go anywhere they want. [With these funds] you're typically taking much less duration, and maybe a little bit more credit risk.

Stipp: Are we comfortable that these funds actually can do what they're saying that they are able to do?

Rawson: No, the jury is still out. This is a relatively new category. Typically you wouldn’t take your risk in fixed income. You take your risk in equities or alternative strategies. This is a new type of strategy that hasn't really been tested yet. We went through a cycle in 2011 where they were very popular because people thought rates were going to continue to rise. Of course, after the European financial crisis, rates continued to actually stay low. It's yet to be determined whether this is a good strategy for your fixed-income investments.

Stipp: Mike, another thing that we will often get questions from readers is why do we report fund flows for exchange-traded funds and for mutual funds separately, especially given that a lot of the funds are identical as far as what their underlying investments are. But we saw some interesting trends when we looked at where ETF investors in a certain kind of fund and where mutual fund investors in a certain kind of fund, how they were behaving in the recent past.

Rawson: Absolutely. We actually get some criticism of why we report mutual fund and ETF flows separately. Well, Morningstar, if anyone, is very open to the ETF structure; we embrace it. We have a separate ETF team essentially who looks at ETFs. But the reason why we separate it out is because ETF investors can be little bit different than mutual fund investors. Mutual fund investors tend to be long-term investors, and they tend to be average investors like you and I or mom and pop just putting their money away into a fund, not necessarily institutions. ETFs are heavily used by institutions, whether they be pension funds. Even other mutual funds and other ETFs invest in ETFs. Sometimes the flows there are more tactical. They tend to reverse sharply, and they're not really reflective of long-term sentiment.

What we're observing here are a lot of outflows from ETFs in the emerging-markets category. Of course, emerging markets have been very weak this summer. They continue to be weak. Institutions are fleeing the area, but we're seeing mutual fund investors continue to invest. I think that's a good story, it's a compelling story. You don't want to sell when the market's underperforming. You don't want to chase returns either. You want to be very disciplined with your investment. We're seeing a lot mutual fund investors continuing to put money into diversified emerging markets, while ETF investors flee that area.

Stipp: Just maybe those individual investors might do better than the smart money perhaps in this case over the longer term.

Lastly, Mike, you mentioned a couple of the funds that were seeing inflows and funds that also were suffering outflows. But we have seen some funds, highly rated funds, getting inflows. The money that investors are putting to work, they seem to be at least finding some of the better funds.

Rawson: Yes. There are a number of Gold-rated funds. Of course, Morningstar went to the Analyst Rating system. We have the Morningstar [Rating for Funds, also known as the star rating], which is past-performance-based. We also have the Analyst Rating, which is a future-based predictive measure of funds in which we are very confident. One of the funds which is doing very well is Oakmark International. Of course, that's run by David Herro. Morningstar.com readers are very familiar with David Herro. He was the Morningstar International-Stock Fund Manager of the Decade, so he has a good track record. He’s certainly putting in another good year. He is up 37% this year. There are just phenomenal numbers in this fund. Again, it's Gold-rated, and it's getting very strong flows. It's something we will probably appreciate using.

Stipp: Mike, great insights, as always, on the Morningstar asset-flows data. Thanks for joining me today.

Rawson: Thanks for having me.

Stipp: For Morningstar, I’m Jason Stipp. Thanks for watching.