Investors Increasingly Turning to Overseas Investments

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

Investors continued to plow money into international equity and taxable bond funds in the month of April. Joining me to discuss Morningstar's latest fund flow data is Tim Strauts, a senior markets research analyst with Morningstar.

Tim, thank you so much for being here.

Tim Strauts: Thanks for having me.

Benz: Let's look at the big headline, which is that international equity continues to receive really good inflows, even though when investors look at international-equity fund performance, it probably hasn't been as good as what domestic-equity funds have enjoyed.

Strauts: There has been a general shift from U.S. equity funds to international over the last several months. International took in little over $40 billion in new flows, and the flows seem to be dominated into the foreign large-blend category, and then also into emerging markets.

Benz: One story we've been monitoring is this ongoing inflow into passively managed products, index funds. Did you see that when you look at the flows into international-equity and emerging-markets equity? Do investors continue to prefer index funds? What kinds of funds are they buying?

Strauts: Broadly in international, investors are still preferring index funds, but if you focus down into the emerging category, it's actually a 50-50 split just last month between passive and active emerging-markets funds. And over the last year, emerging-markets active funds have taken in more money, which is one of the few equity categories where active is actually getting larger flows than passive funds.

Benz: Can you conjecture about what investors might be responding to in terms of choosing actively managed products in emerging-markets equity?

Strauts: There is the idea that in emerging markets, there may be more opportunity for an active manager to provide value, because it's a much larger base of stocks to choose from.

And also there is concern that the two large ETFs in the space--VWO, the Vanguard Emerging Markets Fund, and EEM, the iShares Fund--both track the same index, which is dominated in global multinational companies that often are state owned, and they have a very large allocation to China. So if you buy VWO or EEM, you may not be getting the emerging growth, the big growth story that you're expecting. You are getting firms, in many cases, that look similar to some U.S. firms. So active managers may be avoiding some of these larger firms and looking for undiscovered pockets of opportunity.

Benz: Switching over to fixed income: Let's talk about what's going on with the taxable-bond category, where we have continued to see some pretty good inflows.

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Strauts: There was about $12 billion inflows last month. It's surprising, because interest rates have started to perk up a little bit. The 10-year Treasury has started to rise a little bit just in the last several months. But investors are still plowing money into the intermediate-term bond category. And while intermediate-term bonds don't have the interest rate risk of, say, a long-term fund, they still do have risk, and investors seem to be comfortable with that risk right now.

Benz: In terms of where the assets are going, some of the core intermediate type funds are getting assets. Let's talk about the funds that have been the beneficiaries of new investor dollars, and also talk about the PIMCO story, because I know that's one you've been monitoring. We've seen pretty big outflows from some of the various PIMCO funds.

Strauts: PIMCO Total Return lost another $6 billion in assets last month, which would be an incredible number for any other firm, but with this story, it is actually a big improvement. Just a few months ago, they were losing $30 billion a month in this fund. So, flows have gotten better over the last five months, and based on the current trend, maybe by the end of the year, PIMCO Total Return will be back to breakeven.

But it's still remarkable, the actual size of the outflows. Currently, PIMCO Total Return has about $110 billion in assets. Just a year ago, it had $230 billion. So it lost about $120 billion just in one year.

Now, moving onto the funds that are beneficiaries, it's the same list we have been talking about in the past: MetWest Total Return Bond had another big inflow. Baird Aggregate Bond had another big inflow. BlackRock Strategic Income. And then one interesting one, an actual PIMCO fund, PIMCO Income Fund, the first time on this list in a while, was the number five fund last month.

Benz: Another fixed-income category that saw significant inflows--I consider it a niche fixed-income category--was world bond. It saw some pretty good investor dollars coming in the door. Let's talk about what investors were buying there.

Strauts: World bond took in almost $4 billion in assets last month, and that $4 billion almost came exclusively from the Vanguard International Total Bond Market Fund. That fund is a little bit unique in the sense that it U.S. dollar hedges the bond portfolio, so you don't have the currency volatility you may see in a typical international-bond fund.

I think it makes sense for a lot of investors to hedge their currency risk in their bond portfolio, because looking at bonds, you're oftentimes looking for a lower-risk type of investment. And if you don't hedge the currency, you can see wild swings in performance, as we would have seen recently with the U.S. dollar rising so quickly.

The concern I have about the fund, though, is that it's buying into bonds in Japan that have close to a 0% yield. Bonds in Europe do actually have a 0% yield; the yields in Germany are actually negative for most maturities. So there is some concern that you're buying into bond markets that have lower yields than the U.S.

Benz: Let's talk about U.S. equity. This is interesting story, one we've been monitoring, where we have seen strong outflows from actively managed U.S. equity. But it appears that things have spread now to passive U.S. equities--those funds are seeing outflows as well.

Strauts: We actually saw $7.5 billion in outflow out of passive U.S. equity funds, which is a real surprise. And this outflow was stemming from the flows of SPY, the large S&P 500 ETF. It's seen four months in a row of strong outflows from the ETF.

So investors aren't just moving money from active to passive in the U.S. equity space; they're actually selling U.S. equity right now, which is, again, surprising because the S&P 500 hit an all-time high just this week. Normally when indexes hit all-time highs, investors are allocating to that category, but that's not the case right now.

Benz: We usually don't see contrarian moves. Could it be that advisors are increasingly helping guide investors choices, and perhaps they're coaching on rebalancing at this point?

Strauts: That definitely could be. Rebalancing could also be a factor. I also think that investors are starting to get concerned. We're getting six years into this bull market. You look at the historical record, a six-year bull market is toward the end of the bull market. And many investors after experiencing 2008 may be trying to sell early.

Benz: Not get greedy.

Strauts: Not get greedy.

Benz: Tim, thank you so much for being here. It's always great to hear your insights.

Strauts: Thanks for having me.

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