In Bonds, Active Funds Still Attracting Assets

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Through 2016's first three quarters investors continue to exhibit a strong preference for bond funds as well as passively managed products. Joining me to discuss Morningstar's latest fund flow data is Alina Lamy. She is a senior markets research analyst with Morningstar.

Alina, thank you so much for being here.

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

Benz: Let's dive right into this. I want to start by looking at fixed-income funds, where investors have been placing their bets. And one thing I want to look at is, the dispersion between active products and passively managed products. Here it looks like investors aren't exhibiting a really clear preference--that they're buying some active products, but some investors are also betting on the passives. Let's talk about that a little bit.

Lamy: Exactly. So, the trend, the movement toward taxable bond funds with high inflow started after the January sell-off in the stock market, and it's been going strong throughout the third quarter. Passive funds have received higher inflows a little bit but active funds have received positive flows as well. In the third quarter, the two funds that have appeared consistently on the top flowing list have been PIMCO Income, what a turnaround after PIMCO Total Return and Metropolitan West Total Return Bond. So, in fixed income, unlike in equity, quality active funds are still in demand and they are still attractive.

Benz: The intermediate-term bond funds, kind of the core type products, those were getting the lion's share of fixed-income fund flows recently. But you also noted in your report that the short-term and ultrashort-term bond funds were getting decent flows. What do you think is going on there? Is that investors are just battening down the hatches in preparation for rising rates?

Lamy: Absolutely. That's what it looks like, because with those shorter-term instruments you are sacrificing some of the return, but on the other hand, you are taking on less interest-rate risk.

Benz: OK. It doesn't appear that investors are enthusiastic about every single bond type. There were a couple of categories that have been seeing some redemptions recently. One that jumped out at me was the nontraditional bond group. Let's talk just generally about what those funds are, and I know it's a broad basket. That group saw outflows and also the world bond category at large has been seeing some outflows. Can you discuss those two groups?

Lamy: They are both interesting. The nontraditional category is interesting because those strategies are supposed to perform better in a rising interest-rate environment as opposed to traditional strategies. So you would expect investors to be buying in right about now in expectation of rising interest rates. However, the fact that we are seeing outflows seems to indicate that the interest-rate movement is not that much of a factor in the decision to choose a fixed-income category anymore. And international bonds are really very interesting too because they have been performing really well, about a 17% return year-to-date. So I would have expected to see some positive flows in that area as well. But there are a few funds that have been bearing the brunt of the outflows, Franklin Templeton funds, Global Bond and Global Total Returns, because they haven't been performing that well this year.

Benz: Moving over to U.S. equity, this is a familiar pattern where investors are getting out of U.S. equity funds altogether, that we've seen that category in net redemptions. But underneath the hood you see that it's really the active funds that are getting the big redemptions. Passive funds are getting flows, so they are getting positive flows, but not enough to compensate for what's coming out on the active side. What's going on there?

Lamy: Exactly. It's almost a balanced situation--what's coming out on one side is going into passive on the other side. The U.S. market has been doing pretty well this year. The economic indicators look good. So that is showing in the flows in the sense that large-blend passive equity funds are receiving inflows. But on the active side, those funds just can't seem to turn around. The money is just pouring out.

Benz: So the big core-type passive products, the S&P 500 trackers and the total market trackers, those have been gathering all the assets at the expense of categories like, I noticed large growth continues to be a category that is losing quite a bit of assets every month after month it seems?

Lamy: Large growth hasn't been in favor. Large blend has been popular with investors. And like you were saying, the index funds and ETFs, the SPDR S&P 500 has been an interesting exception because it's been really volatile recently; large inflow and then an outflow this month.

Benz: So, flows have been volatile into the SPDR?

Lamy: Yes.

Benz: Let's take a look at international equity. You note that over the past year investors have had a really strong preference for emerging-markets and that has really been a pronounced trend just over the past several months?

Lamy: Over the past several months, flows into emerging-markets have been positive and flows for developed markets have been negative. Emerging-markets have been doing really well this year, about a 16% return. So, clearly, flows are chasing those returns. But on the other hand, also looking forward, there is expectation for more growth from emerging-markets than from mature developed markets. And in terms of active versus passive, international equity seems to follow the exact same pattern as U.S. equity, passive is getting most of the flows.

Benz: Taking a look at fund families, one interesting thing just jumps out at me is that you've got Vanguard and BlackRock, typical passive asset gatherers. They've been among the most prodigious asset gatherers over the past several years. Another name though is high on the list of firms with index funds that have been gaining assets and that's Fidelity. Let's talk about that.

Lamy: That's been very interesting recently because Fidelity is not thought of as passive specialists than investors might; however, they did realize that they had to start competing in that game. They couldn't just focus on the active side anymore. So, a few months back they started reducing fees on some of their passive products, and it's been paying off. We started seeing inflows into those passive products and even though they keep experiencing outflows on the active side, if they are able to offset at least some of those outflows with the passive inflows then I would say they have a pretty good position right there.

Benz: OK. Lower-margin products, of course, though the passive products?

Lamy: They are, but instead of having all the flows go to Vanguard, if you can at least get a piece of that pie.

Benz: Keep some of it, yes. Let's discuss some of the firms that have been losing active assets. Fidelity, you mentioned, is one of them. Franklin Templeton, you also mentioned. And is that coming mainly from Hasenstab's World Bond Funds or is that coming from other parts of the Franklin Templeton line?

Lamy: Mainly from those two funds, the Global Bond and the Global Total Return. And they appear constantly on the bottom flowing list in my monthly report. And in general, it is a bitter irony, but sometimes I see on the active side all the flows are negative except some for the passive firms. So Vanguard and State Street, for example, will have inflows and all the other active specialist providers will have outflows. So, overall, as an investor, the proposition is, there are two important things, cost and quality. So, as a firm, as a provider, if you are able to provide clear value at a reasonable cost, I would say then you are able to attract the investors' attention.

Benz: Last thing I want to hit on with you, Alina, is PIMCO. And you mentioned PIMCO Income being a big asset gatherer. PIMCO Total Return, though, you also hinted at has been on the list of funds that have been seeing big outflows. Let's talk about that. The flows started when Bill Gross left PIMCO Total Return. Have the outflows slowed down in recent years?

Lamy: They've slowed down. So since 2014 PIMCO has had a very, very difficult time with outflows from PIMCO Total Return mainly and from some of its other funds, but I think this is remarkable comeback with PIMCO Income showing up consistently in the top flowing list for the past year or so. They have been there for a while. MetWest and DoubleLine have been there as well. But PIMCO are still some of the most experienced, some of the best fixed-income managers around and even now it's only this one fund. It looks like they are still in the game.

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

Lamy: Thank you for having me, Christine.

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