Investors Grow Cautious on Stocks

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Although the equity market was relatively strong in May, investors weren't buying traditional U.S. equity mutual funds. Joining me to discuss what they were buying is Mike Rawson, a fund analyst with Morningstar.

Mike, thank you for being here.

Mike Rawson: Thanks for having me, Christine.

Benz: Mike, when you look at fund flow data, it looks like investors have been pretty tepid on at least traditional U.S. stock funds so far in 2014.

Rawson: May was the worst month in about 17 months in terms of flows to U.S. equities. There were actually outflows of about $6-$7 billion. Some of that may not have been a true reflection of investors' sentiment, but when you look overall so far this year, the first five months of the year, flows are down from what they were last year, and particularly for U.S. equities.

Benz: When you net it out and add back in what's been going on with index funds and ETFs as well as collective investment trusts, what do you see about investor sentiment, based on fund flows?

Rawson: I think investors are somewhat skeptical or cautious. You don't see the wild enthusiasm that maybe you saw a year ago. Flows are down.

A couple of trends we've observed is that, typically in the past, outflows for mutual funds were offset by inflows to ETFs. That hasn't been the case so far this year. In fact, there have been some outflows to some major exchange-traded funds.

The SPDR S&P 500 ETF (SPY) for example has had pretty big outflows, and there has been a market-share shift between the SPDR fund, which is the largest ETF, and a couple of its lower-cost, more-efficient competitors, such as the Vanguard S&P 500 Fund (VOO) and iShares S&P 500 Fund (IVV). Both of those are lower cost. Traditionally people chose the SPDR because it was more liquid, and it was the first, so it had more name recognition, but we are starting to see some investors switch to the lower-cost, more-efficient S&P 500 ETFs.

Benz: You mentioned in your recent report that we saw some flows coming out of U.S. equity traditional mutual funds and moving into what are called collective trusts. Let's talk about what collective trusts are, and also what you think is the possible reason behind this recent shift.

Rawson: Collective investment trusts are pooled investment vehicles. In that respect, they are similar to mutual funds. But unlike mutual funds, they are not subject to the same SEC reporting requirements. They don't have as much disclosure. Typically they are viewed as safe investment vehicles. However, they don't have the same level of reporting disclosure that a mutual fund would. So they have some lower administrative costs.

Occasionally you see large institutions or 401(k) plans offer CITs to their clients, because they have a lot of assets and they are able to pool their money and get access to this institutional type of account at a lower cost. The information is maybe not as publicly disclosed, but because it's a pension fund or a 401(k), they are able to do the due diligence and assess that this is a safe fund.

As you mentioned, last month and in April we had seen some flows from Fidelity products into collective investment trusts. What I find interesting about that is we've seen over the past several years a lot of inflows into passive products, and not as much growth in active products, potentially because of the expense ratio difference between active and passive. So as we are now starting to see some flows into collective investment trusts, it may be a way for an active manager to say, look, I can offer you a discount on this strategy, but I can't offer it on the mutual fund. If you are an institutional investor, I'm going to give you access to a collective investment trust at a lower expense ratio, but I don't want to cut my expense ratio on my mutual fund, because that's where a lot of my profits come from.

Benz: Switching over to fixed income, it's been a surprisingly strong year for the fixed-income markets, and investor flows show that investors are buying bond funds. What types of bond funds have they been buying?

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Rawson: They've gone back to core bond funds, which is what they really were exiting from last year. Core bond funds are receiving inflows, but you still see strong flows to this nontraditional bond category. This category offers the promise that it's going to do well in any environment. That's a promise that has yet to be fully tested. There are a few funds in that category that have done well and a few funds that haven't, so you have to do a little more due diligence when you are looking at a nontraditional bond fund and make sure you understand what you are buying.

Another area of the bond market that investors were buying last year, which they have now started to pull away from, is bank-loan funds. Bank-loan funds had a lot of inflows last year. They have floating interest rates. So the idea was that if interest rates were to rise, a bank-loan fund wouldn't get hurt as much as a long-duration type of bond fund.

Now that interest rates are ticking down, investors are reassessing that investment thesis, and bank-loan funds have had withdrawals for the last two months for the first time in about two years.

Benz: So, bank-loan funds certainly haven't crashed, but you think it's just the fact that yields are relatively smaller than what you might earn on a core type of fund … that's why investors are maybe making that trade-off?

Rawson: I think the whole fear of rising rates is less current in the conversation. What we saw last year was a little bit of a kneejerk reaction to some comments Ben Bernanke made about tapering. We see that, even though the economy has improved, the Fed hasn't really signaled that we're going to aggressively ease stimulus or we are going to aggressively tighten. So interest rates have fallen since the start of the year, and as a result, investors are less sensitive or less concerned about the rising interest rates than they were a year ago.

Benz: PIMCO Total Return had another tough month. What's going on at that fund and also at PIMCO more broadly?

Rawson: PIMCO Total Return had, actually, another month of outflows. Since the outflows started a year ago, it's been about $60 billion in cumulative outflows, which is just tremendous when you think about a fund having $60 billion of outflows. And, again, I think it's people both reassessing the interest rate risk that they were taking and reassessing PIMCO as a firm overall, because of the management changes that have gone on there.

But we haven't lowered our rating on PIMCO Total Return; it's still a Gold-rated fund. We have reassessed our rating of PIMCO as a firm overall, but I would remind investors not to follow the crowd necessarily, and think that just because everyone else is selling, I need to sell. I don't think it's going to impact the performance. In fact, the fund has had positive returns year-to-date.

Benz: So even though PIMCO Total Return has been seeing asset outflows, the flows into core-type bonds have been pretty strong. What types of funds do you think are picking up assets that perhaps PIMCO Total Return is losing?

Rawson: There are a handful of funds that have gained market share. Metropolitan West Total Return Bond Fund has gained market share. Another one that had inflows last month that we haven't really talked about much lately is DoubleLine Total Return Bond Fund. I think investors generally are going back to core bond funds. It's just that investors may be a little bit skeptical about going back to the PIMCO fund at this moment.

Benz: In terms of the asset class categories that have been seeing the biggest inflows, the alternatives category is a big winner. But one of the category's biggest funds has actually been seeing outflows. What fund is that, and what is driving the outflows?

Rawson: The MainStay Marketfield Fund has been the darling of the category. It's attracted tremendous flows over the past several years, mainly because they had very good risk-adjusted performance. I throw that word "risk-adjusted" in there because even while the market took off, they didn't keep up with the market. But on a risk-adjusted basis, it did very well. A lot of investors have been skeptical about going back fully into the equity market. This is a long-short product, which offered the appeal of participation in the equity market, but maybe some risk control.

Investors put a lot of money into this fund--up to $20-$21 million in February. But the performance has been weak so far this year. So again, we're seeing a kneejerk reaction where investors have already started to pull money out of the fund. Morningstar fund analyst Josh Charney recently updated his report on the fund, and he still rates it Bronze. He thinks the outflows were related not to the bloat or the growth of the fund, but really to a couple of poor macroeconomic calls, which were rare for the fund; the fund hasn't made those types of missteps in the past. So it's not something we expect to continue, and we've maintained our rating on the fund.

Benz: Mike, always great to hear your insights. Thank you for being here.

Rawson: Thanks, Christine.

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