Investors Remain Skeptical of Stock Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Despite fairly strong U.S. equity market performance, investors have continued to show a preference for bond funds. Joining me to discuss the latest asset-flows data is Michael Rawson. He is an analyst with manager research for Morningstar.

Mike, thank you so much for being here.

Michael Rawson: Thanks for having me, Christine.

Benz: Mike, we've been watching this trend for a few months now. We've seen relatively decent performance for U.S. stocks so far in 2014, but investors are buying bond funds. Why do you think that's happening?

Rawson: Just taking a look at the stock market, last month was the second month in a row where we saw outflows from equity mutual funds. And if you get back in ETFs, the inflows are mildly positive. But for the most part, mutual fund investors were pulling money out of the U.S. stock market. I think that has to do with the fact that the stock market appears to be fully valued. If we look at our price/fair value estimate, driven by our equity analysts, the stock market is at 103% of fair value, so the future returns are maybe still positive but not as good as they would have been maybe a year or two ago.

I think investors now are maybe a little more skeptical about putting money into the market. Then if you go back, after the financial crisis, there were outflows from stocks, but they weren't that strong. It was kind of mild, so we saw mild outflows. Over the past year, we've seen mild inflows. Now it's turning again to what might be outflows. So investors really are not that excited about stocks at this time.

Benz: To the extent that they are adding to U.S. equity though, it does appear that they're showing this preference, which we've been observing for a few years now, into exchange-traded funds and index products.

Rawson: That trend continues. ETFs are getting strong flows, not as strong as they were in the past but they are still getting strong flows.

Benz: Let's take a look at what investors are buying this year when they are buying bond funds. They do appear to be buying some of the core type fixed-income funds, correct?

Rawson: Sure, which is really a surprise. A year ago, there was about an $80 billion outflow from core intermediate-term bond funds, and this all started in May and June of last year when the talk about the taper really ramped up. Now you're actually seeing inflows into these categories. It's quite surprising because we would have expected interest rates to kind of continue to rise, but they haven't. Interest rates have stabilized. If anything the longer rates have come down a little bit, and you see investors, maybe not wanting to put money into stocks, so they are putting money into bonds and rebalancing into bonds, which is probably a good thing.

My concern, though, is that you could have another knee-jerk reaction once interest rates start to rise.

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Benz: PIMCO Total Return, though, is bucking that trend a little bit. The redemptions continue there. But investors are buying another PIMCO fund, PIMCO Income. Why do you think they're supplanting one fund with the other?

Rawson: I think it's performance. PIMCO Income has had very good performance, and I think PIMCO Total Return is bucking the trend of inflows into intermediate-term bonds. That's I think because PIMCO, as a firm, has some issues with management turnover and maybe some people reassessing whether or not they should be in that fund or that firm. So that fund has had outflows, even though we're seeing inflows to most other intermediate-term bond funds.

Benz: Bank-loan funds have been seeing redemptions recently after very strong inflows for the past year or even more. Why do you think the tide has turned on bank-loan investments recently?

Rawson: Again, it gets back to I think the fact that interest rates have stabilized. Bank-loan funds hold appeal if interest rates were to rise modestly and the economy were to improve because bank-loan funds have a lot credit risk and not as much interest-rate risk. They're a little bit defensive against rising interest rates. Interest rates haven't risen, so investors seem less concerned about that. Again, I think, once interest rates rise, as long as the economy is strong, I think you could see flows go back into bank-loan funds. But for now, for the third month in a row, we've had outflows from bank-loan funds.

Benz: Mike, let's take a look at the foreign-stock fund flows. We have seen better market performance in general in the U.S. and yet investors continue to add new dollars to foreign-stock funds.

Rawson: Performance has been better in the U.S. It's still been good in developed international markets, but I think what's happening there, the reason why we're seeing stronger flows into developed international markets is that for years investors had avoided that segment of the market with the European financial crisis. Remember, their financial crisis sort of took place after ours in the United States, so now you're seeing investors sort of catch up and putting money into those areas.

Benz: How about the types of funds that investors are buying when they are looking at foreign-stock funds?

Rawson: Interestingly, you are seeing flows into active products. So active tends to be a little bit more popular internationally than it is in the U.S. In the U.S. we've seen this huge trend where investors are going with index funds; that's not as strong internationally. So internationally you've seen lot of inflows to foreign large-value type of funds.

Benz: When you look at the allocation category, that's a category that we've not talked a lot about, but we've seen very steady inflows into allocation funds. Do you think that's mainly due to the growth in the target-date fund industry, or are investors buying other types of funds, as well?

Rawson: Absolutely, it's the growth of the target-date fund industry and 401(k) plan options. So when we look at fund flows, typically we'll exclude a fund-of-funds, because we don't want to double count their flows. However, when you look at the amount of money that's in those funds of funds, it's actually now equal to the amount of money which is in the allocation funds which aren't funds of funds. These are the old-style allocation funds, hybrid funds you might call them, which would invest in individual stocks and bonds. They've got about a $1 trillion in those types of funds, but now there's also $1 trillion in these, what we call, funds of funds. Target-date funds are a prime example of those, and that growth has taken place over the last 10 or 15 years. It's just tremendous growth, and that's because they've been widely adopted within 401(k) plans and retirement plans. So we think that's a good thing. These investments tend to be very easy to use and investors usually have a very fair investment outcome.

Benz: Switching gears and looking at the fund family sweepstakes, the Vanguard juggernaut continues, but let's take a look at a couple of other firms that have been doing very well in terms of gathering new inflows. Dodge & Cox, you note, is coming out of the gates with very strong inflows. What funds within the family are people buying?

Rawson: Dodge & Cox has had their strongest flows so far this year in I think about seven years, since before the financial crisis. So, it's really quite amazing. They've got a small lineup of funds, but the funds they do have are all very good. So, there are three funds, in particular, Dodge & Cox International Stock, Dodge & Cox Global Stock, and Dodge & Cox Income, which is a bond fund. I think they're all Silver-rated, if I remember correctly, and they all have had very strong performance and strong flows over the past six months.

Benz: Now, Putnam is another name that had kind of fallen from favor in recent years, but it has found a couple of winners with a few funds garnering strong inflows recently. Let's talk about those products, Mike?

Rawson: The two funds at Putnam that are generating strong flows are Putnam Capital Spectrum and Putnam Equity Spectrum. These are two funds that are both managed by a gentleman name, David Glancy, who came from Fidelity. He went to a hedge fund and now he is back managing mutual funds with Putnam. These funds invest in leveraged companies, and the funds also will vary their stock and bond and equity exposure. David Glancy has timed it very well. We've had this bull market, and these funds have attracted a tremendous amount of assets. My concern would be that these are funds that should do well in a recovering economy. These are leveraged stocks that were beaten down, and now they are doing really well. The question is: How is it going to hold up if the economy slows or if interest rates were to rise, given that these are very leveraged companies?

Benz: Mike. Thanks for being here. It's always great to hear your insights.

Rawson: Thanks for having me, Christine.

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