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Investors Head Toward the Exits of Active U.S. Funds

2015 saw the largest outflows from U.S. equity funds--driven by redemptions at actively managed funds--and the largest inflows to international-stock funds.

Christine Benz: Hi, I'm Christine Benz for U.S. equity-fund flows ended 2015 with a whimper. Joining me to discuss the latest fund-flow data is Alina Lamy--she is a senior analyst with Morningstar's market-research team.

Alina, thank you so much for being here.

Alina Lamy: Hi, Christine. Thank you for having me.

Benz: You monitor fund flows for Morningstar, looking at that intersection between investor behavior and inflows into funds. We have continued to monitor outflows from U.S. equity funds for the better part of 2015. It looks like they really didn't get any better in December, and U.S. equity funds were in outflows for the whole year.

Lamy: They were indeed. Actually, 2015 was the year with largest outflows out of U.S. equity fund and, on the other hand, the year with the largest inflows to international-equity funds. There are a few reasons why this happened. One reason is that the Fed just raised interest rates--contractionary policy for the first time in 10 years. Meanwhile, the European Union is still in quantitative-easing mode. Investors might be seeing higher potential returns overseas in the future. This is unusual because flows tend to follow performance, but this is looking more like an anticipatory mode.

Benz: When you look at U.S. equity, it looks like there were inflows into passive products, but they didn't make up for all of the money coming out of active funds.

Lamy: Correct. The large outflow for U.S. equity funds consisted of very large outflows out of active and inflows on the passive side. That's been a consistent pattern we've been seeing for a few years now.

Benz: We've been monitoring these flows into international equity--and performance hasn't been that good. Actually, U.S. equity funds generally outperformed foreign-stock funds during 2015. You mentioned that maybe investors are looking ahead and trying to capture what they think might be greater growth overseas; but are there any other factors that you think are driving those flows into international-equity funds?

Lamy: There is the forward-looking aspect of it, and another reason is that a lot of these flows are coming through the retirement-plan channel through funds of funds--specifically target-date and target-risk funds. A lot of these plans have been increasing allocations to international equity recently--Vanguard is one example. They've been enhancing their diversification for their target-date funds with increased international-equity exposure. It's worth noting that a large portion of these international-equity flows are coming through that retirement channel because allocations have been increasing to international equity.


Benz: So, institutions are saying, "We think you ought to potentially get away from your home bias a little bit and boost international equity." It's not so much that individual investors think that it's a great idea to buy international equity right now.

Lamy: Exactly. It's not a case of U.S. investors taking all of their money out of U.S. equity and switching completely to international equity. It's more the case that institutions believe that international equity is a good diversifier for a balanced portfolio, and the flows we've been seeing reflect that.

Benz: Taxable bond: One story that I know you and your team have been watching closely has been this PIMCO story where for 2015 we saw pretty large outflows from active bond funds--most of it driven by redemptions at PIMCO.

Lamy: PIMCO has been suffering large redemptions, although monthly flows have been decreasing recently. So, they're doing a little bit better. Actually, for December, their press release reported a positive inflow, but that's because they have taken capital gains into account. By Morningstar's calculations, we were still reporting an outflow for them.

Benz: PIMCO Total Return (PTTRX) actually had quite a good performance in 2015--or at least relative to its intermediate-term bond fund peers.

Lamy: They have done fairly well, but it seems that the inertia that's carrying investors out of that fund hasn't stopped--it still has seen outflows. However, another PIMCO fund, PIMCO Income (PONAX), has become more and more popular. Although the inflows into that fund don't compensate for the outflows from Total Return, that's a fund that has been showing up as one of the top-five inflowing funds lately.

Benz: In this category, when you look at both passive products as well as active products, it looks like there were actually positive inflows in 2015, mainly because the passive products really picked up the slack. Where active funds were losing money, passive funds were gaining.

Lamy: It's true that the same pattern we've seen in U.S. equity--the shift from active to passive--has become more prevalent in taxable bonds, too. However, within active funds, there are a few funds that are still receiving inflows. For example, MetWest [Total Return Bond (MWTRX)] has been one, DoubleLine [Total Return Bond (DLTNX)], and few others that are still favorites among investors.

Benz: High yield has been a category that was very much in the news in late 2015. You had this Third Avenue Focused Credit Fund that ran into problems, and there were reverberations throughout the high-yield fund sector. Let's talk about that a little bit.

Lamy: High yield is both high yield and high risk. Investors tend to go to these types of bonds when yield is becoming really difficult to find elsewhere. If you look historically, interest rates have been near zero since 2008, and that's when flows into high-yield bond funds really started growing. In 2013 when there was talk of rising interest rates, the flows began to decline, and we actually had outflows in 2014 and 2015.

However, another big factor playing a role in the high-yield equation is the price of oil because many of these bonds come from the energy and basic-material sectors. So, with sinking oil prices, bankruptcy risk in these sectors has increased, and investors slowly started taking money out of high-yield bond funds. And then, of course, in December, Third Avenue happened, and that scared investors out of high-yield bonds even more.

Benz: When we look at the fund-family flows--we touched on the PIMCO story, obviously--but you note that one family that has been affected by the overall scare in high yield has been Franklin. Let's talk about that a little bit because it's not so much that they've seen big outflows from a dedicated high-yield fund but some of their other, broader products.

Lamy: Franklin has seen significant outflows, especially from two of its fixed-income funds. They're not high-yield funds; they are global--Templeton Global Fund (TPINX) and Franklin Income (FKINX). Those two showed up on the bottom-flowing list in December, and they've been affected by that for a while.

Benz: So, Franklin Income tends to have some high-yield bonds in its portfolio, some lower-quality bonds. Templeton Global Bond's complexion is different, but it's the emerging-markets exposure that has hurt that fund, right?

Lamy: Exactly.

Benz: On the other side of the ledger, Vanguard continues to see very big inflows. What types of products are investors embracing at Vanguard?

Lamy: Vanguard is unstoppable right now. Its index funds are very popular with investors, and it has also been seeing some inflows on the active side. It's almost ironic that in some months when active-fund families are seeing outflows, active Vanguard funds are still seeing inflows. Other fund families that have been doing well in terms of flows are MetWest, with their bond funds, and WisdomTree, with their currency-hedged ETFs.

Benz: When you look forward into 2016, what are the key things that you'll be keeping an eye on as you're monitoring fund flows?

Lamy: We'll definitely be watching high yield for a while now. International equity and U.S. equity--they are a given. And I would also want to look a little bit more into these retirement-plan flows and how much they drive individual-fund flows--exactly where the flows are coming from.

Benz: You mentioned, in the case of Vanguard with its target-date products, the allocation changes that they are making actually have the potential to change the flows that we're seeing into some of these asset classes?

Lamy: Exactly. If a big institutional retirement plan makes allocation changes, that's going to change the flows significantly, and we want to keep an eye on that.

Benz: Alina, thank you so much for being here to share your insights.

Lamy: Thank you so much, Christine.

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