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'Great Rotation' Into Stocks Runs Its Course

Investors have been putting money back into bond funds as interest rates have unexpectedly dropped this year.

'Great Rotation' Into Stocks Runs Its Course

Christine Benz: Hi, I'm Christine Benz from Morningstar. Has the so-called great rotation fizzled out? Joining me to discuss that topic is Michael Rawson, he's an analyst with Morningstar's manager research team. Mike, thank you so much for being here.

Mike Rawson: Thanks for having me, Christine.

Benz: Let's take a look at this: There had been this much-ballyhooed rotation into equities. We're seeing strong flows out of bond funds going into equity funds. You say the most recent data run, looking at fund flows, does not show continued strength in equity fund flows.

Rawson: You are absolutely right. The great rotation certainly did happen. We started talking about it at the beginning of the 2013--that people had anticipated for the longest time that all of this money has gone into bond funds, and at some point, this is going to end with interest rates being so low that people are going to turn to equities. And when the Federal Reserve started talking about removing stimulus in June of 2013, we finally saw the great rotation: Money came out of bond funds and started going into equities a little bit.

But what's happened recently is that the equity market really appears fully valued. Investors aren't as enthusiastic about going into equities. Interest rates have started to come down, and so investors have put money back into bond funds. So, the great rotation certainly happened in 2013, and it appears to have run its course. Every month this year over the past eight months, bond fund flows have exceeded U.S.-equity fund flows, which is really quite surprising given that a year ago no one would have predicted that. People would have said interest rates are going to continue to rise and that hasn't been the case.

Benz: Another trend that you've been monitoring has been this flow into passive-equity funds. When you factor them into the mix and look at passive-plus-active equity, are flows still pretty disappointing recently?

Rawson: So, in U.S. equity they are. There are negative flows to the active U.S. equity and positive flows to passive U.S. equity--mild. But what we are seeing, where the money is really going is the international funds and sector funds. Sector funds are a smaller subset of the universe. But we split those out from U.S.-equity funds because they tend to also hold a lot of international stocks; they tend to be industry focused, so they go across borders.

Sector funds are a smaller part of the pie, but they are a growing part of the pie because investors are seeking out these funds often trying to get some yield. So, we see some popular sector funds, such as real estate investment trust (REIT-type) funds and master limited partnership funds. These funds have gained in popularity, and flows have continued to go into international markets.

Last month, that pulled back a little bit as we saw Europe had negative GDP numbers, and so some of the inflows that Europe had been getting came back in August. But overall for the past eight months, flows to international funds have been very strong.

Benz: So, I think that investors might be confounded by this, given that U.S. equities had until very recently generally outperformed foreign-stock funds. What do you think is driving the interest in international?

Rawson: I think it's part of an allocation story. The U.S. market has appreciated so much. Investors have a large allocation to U.S.-equity funds just from market appreciation--even if they haven't added money into those funds overall. In 2013, the market was up 30%, so your assets in U.S.-equity funds were up 30%.

The developed European markets and developed Asia haven't kept up with the performance of U.S. funds. So, from an asset-allocation standpoint, investors have been allocating to those international markets as a way of catching up where they had underinvested, perhaps, in the 2011-12 timeframe.

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Benz: Another fund type that you've been tracking in fund flows is so-called strategic-beta funds. Let's first talk about what these funds are, generally--how the flows have looked. And I'd also like to hear your take on whether there is really anything new in strategic beta that maybe wasn't already around before.

Rawson: Strategic-beta funds are index funds, first of all. So, they track an index, but what differentiates them from traditional indexes is that they will follow a nontraditional index--a non-market-cap-weighted index.

So, you think of an index like the S&P 500, the Russell 1000, the Barclays' Aggregate Bond Index--these are market-cap weighted, which means the bigger the security, the bigger the weight in the index. And this makes sense. Apple and Exxon are huge companies; they should make up a bigger part of your portfolio--

Benz: In terms of market value.

Rawson: In terms of market value and percentage in your portfolio. However, these strategic-beta funds typically will take some type of active bet against a market-cap-weighted fund along some dimension or some factor of expected returns.

So, these are factors that have been studied for long time and are well known. They're factors that active portfolio managers try to exploit. These are factors such as value, momentum, and small size. So, strategic-beta funds basically attempt to exploit these factors within an index vehicle. So, you get some of the benefits of indexing--where you generally have low turnover, you are generally very transparent, and you could have a low expense ratio--but yet, at the same time, you're trying to outperform a market-cap-weighted index.

Now, you ask me if there is any legitimacy to these strategies: I would say that the jury is still out. We know that some of these factors have worked over long periods of time, but they don't always work and certainly there will be many years where a factor doesn't work as well. For example, over the last 30 years, small-cap stocks haven't outperformed large caps. So, since the inception of the Russell 2000 (which is a small-cap index) back in 1978, it actually has underperformed the Russell 1000 from 1978 to 2014. That's quite a long time.

Benz: It's a long period.

Rawson: That's a long time to wait for outperformance and not get it. Now, there are cycles in there where small caps outperform, but they don't always. So, what you are really getting is exposure to different risk factors. If you think those risk factors are going to outperform over the long term then, yes, go ahead and place your bet on these strategic-beta funds. Again, there is no guarantee.

What I think it really does, though, is it puts pressure on those active managers who charge a high fee just for tilting their portfolio toward these factors and maybe held 100 to 200 to 300 securities. Those are what we would call closet index funds.

So, strategic-beta funds are really going to put a lot of pressure on these closet index funds--or maybe sort of those in-between-active-and-passive funds--because now you can get those types of funds in a much less-expensive vehicle. We used to call these types of funds "quant funds," and I think the strategic-beta or smart-beta funds are very similar to the quant funds; they just have a lot better marketing. They have this appeal of "This is smart beta--somehow this is better than traditional beta." Well, it's not better; it's different.

Benz: In terms of flows, it sounds like this has been a hot category. Let's talk about how many dollars have been flowing into some of these fund types.

Rawson: Strategic beta is a smaller subset of the ETF universe, so there's definitely more assets in market-cap-weighted ETF products. However, the growth in terms of organic growth rate is going toward strategic beta. I think they've had something like 15% organic growth rate. I'm talking about U.S.-equity-focused strategic-beta funds, whereas the market-cap weighted had about 10% organic growth rate.

So, the growth in strategic beta has been faster. Certainly, there's a lot of currency and a lot of buzz around strategic beta, currently.

Benz: We haven't created a new category for strategic beta; we just slot them in whatever style category they belong in.

Rawson: Exactly. So, for users of Morningstar Direct, it's not a new category, per se. But there are data points and attributes that will help you screen and analyze for strategic-beta funds.

Benz: Let's take a look at the fund-family action and some specific funds. You highlighted the strength in international-equity-fund flows. Oakmark continues to see some very strong numbers in terms of performance but also in terms of asset gathering.

Rawson: It's truly impressive. Oakmark is a fund that has some success in marketing funds directly to investors, and that's something that's difficult for a lot of fund companies to do. There are some firms that are very successful with it; they built a great brand name. Of course, Vanguard comes to mind. Oakmark (OAKMX) also will sell its funds directly. They benefited from some great portfolio managers. They have two Gold-rated funds, which have gathered a lot of assets. Oakmark International (OAKIX) and the Oakmark Fund itself have allowed the firm to gain market share over the past few years.

Benz: You mentioned that Vanguard flows continue to be very strong in passive products mainly but also a little bit into active equity--kind of bucking the trend that we've been looking at where active equity has been losing.

Rawson: It is surprising that, among the top 10 asset-manager firms, Vanguard is one of the strongest in terms of flows to active products. Many of their active products follow the same attributes of some of their passive in terms of being low fee. So, I guess theirs is more of a fee story than necessarily active versus passive. And a few other firms have generated strong flows in active. JPMorgan comes to mind. They've done a phenomenal job of selling their funds through their proprietary channel--through their bank branches. A couple of other firms where their active funds have had success include Putnam and MFS.

Benz: Over on the fixed-income side, you say that Metropolitan West has been one of the biggest asset gatherers. What's going on there?

Rawson: I think Metropolitan West and a few other bond-fund firms are benefitting from the outflows from PIMCO.

Benz: PIMCO Total Return (PTTAX).

Rawson: PIMCO Total Return, specifically, had outflows again last month. In fact, we've seen outflows actually pick up despite the fact that money is going back into the category overall. So, people are still choosing those core bond funds, but they're choosing to go with a firm other than PIMCO.

Benz: You looked at some Federal Reserve data that takes a different window into where investors are putting their dollars and found that the assets in mutual funds are at a record-high level, but savers are making some different choices. Let's talk about that data.

Rawson: Mutual fund assets and household assets in mutual funds are at an all-time high in terms of the percentage of their net worth, which is encouraging. So, investors have more of their assets in mutual funds than they've ever had before. Real estate has bounced back a little bit, obviously, with the rebound in real estate prices. But what was interesting when I looked at the data is that money market funds haven't kept up with the rise in mutual fund assets. So, typically, you'd think they would go in tandem. People would hold some money in reserve in a money market fund and some money exposed to the market.

However, that hasn't been the case. But what has increased is checking accounts. So, I think what's happening is that investors say, "There is no reason for me to take the money that's accumulating in my checking account, write a check to my broker, and deposit this into my money market fund, if there is no yield." With the Federal Reserve keeping interest rates so low and with money market fund regulation requiring money market funds to invest in higher-quality securities (such as treasury bonds) and keep the duration very short in short-term securities, money market funds just can't offer an attractive yield to compete or to even entice investors to take that money out of their checking accounts and put it into a money market fund.

So, money market fund assets have really shrunk. Checking account assets have increased; time deposits, which are savings accounts or CDs (certificates of deposit), they've increased a little but not as much as the increase in checking accounts. So, it's really interesting. I think it's going to be a challenge for the money market fund industry of how to attract assets when there is no incentive there for people to keep money in a money market fund--if it doesn't have the convenience. And, really, I don't think money market funds have the same level of trust that people have in their corner bank.

Benz: They're not FDIC-insured for one thing.

Rawson: Absolutely.

Benz: So, what do you think will drive renewed interest in money funds? Will it simply be when yields go up, and they are able to offer perhaps a little bit of a yield differential versus just a cash account?

Rawson: That may happen, but what you may also have is more short-term bond funds. There has been a rise in popularity of short-term bond funds not only because interest rates are low and people are afraid that when interest rates go higher that their longer-duration bond funds will get hurt, but also because the short-term bond fund isn't subject to the same regulation as the money market fund. They can have a fluctuating NAV [net asset value], and they can offer you a higher return. So, there is going to be a little bit of a migration or a bifurcation. People who want really low-risk assets will stay with their money market fund. People who want a little bit more return and are willing to take some risk will switch into an ultrashort-term bond fund.

Benz: Mike, thank you so much for being here.

Rawson: Thanks for having me, Christine.

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

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