A Surprise for Active Funds in 2017

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The final data are in: Passive products had another blockbuster year in 2017. Joining me to discuss the latest data on the fund flows front is Alina Lamy. She is a senior analyst in Morningstar's Quantitative Research Group.

Alina, thank you so much for being here.

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

Benz: I tipped people off to the big headline here and they are probably not surprised. When you look at fund flows, as you do, we have just seen this torrent of assets going to passive products. Active funds really haven't had a chance on the fund flows front recently, have they?

Lamy: It's been a really interesting year. It's been a year of record flows into passive products overall, almost $700 billion.

Benz: Relative to 2016, they were higher?

Lamy: They were much higher. Almost $700 billion and a record year. In fact, they have done nothing but go up for the past six consecutive years since 2012. But--and this is the really good news for active funds--the 2017 outflow was really minimal. It was an outflow, it was in the negative. But it was really close to zero as opposed to 2015 and 2016 when the outflows were really heavy. It's almost a victory. Even if it's not positive, it's not an inflow, it's almost a victory for active funds.

Benz: I want to drill into a couple of particular spots that jump out as being interesting. One is the taxable bond space. That's one area where it doesn't seem that investors have completely thrown in the towel on active management. When you look at flows, you actually see that actively managed taxable bond funds had positive inflows last year as did the passives. What's going on there?

Lamy: The flows are all positive for taxable bond funds, and they are divided almost equally between active and passive. That's interesting. It kind of makes sense because there are way more bonds out there than there are stocks. It's really difficult to be a fixed-income active manager, to know which bonds to pick and which sectors to go into to get that extra return while managing risk at the same time. For that reason, it seems investors are really placing a lot of value on the expertise of a fixed-income active manager.

Benz: Do you see any difference when you look at flows in terms of the types of bond funds that investors are buying? Are they buying the plain-vanilla passive products and looking to active management to delve into some of the funkier, more credit-sensitive sectors? Do you see any trends on that front?

Lamy: That is very interesting. It would make sense that you would see that, but not really. The largest category in taxable bond funds is intermediate-term bond funds and that's the most popular one. There, exactly as for the overall taxable bond category group, the flows are divided almost equally between active and passive. It makes sense because it's a good, moderate, middle-of-the-road option. With the short-term bond funds, you get a low return. With the longer term bond funds, you are exposing yourself to higher interest-rate risk. From that point of view, intermediate is a good middle-of-the-road type of option.

Benz: The elephant in the room really in terms of these big flows into bond funds isn't so much the active/passive divide. But really, we had such a great year for equity funds and the equity markets in general, why were investors buying bond funds at all in 2017?

Lamy: There can be a couple of reasons. First of all, we have been in a bull market for stocks for nine years now. At that point, with that type of growth, you can see allocations get a little bit out of whack. When you have had such high growth, you can have a really high stock allocation and you can be exposed to more risk that way. A lot of it can be investors rebalancing, basically getting back on track to an allocation that suits their long-term goals and their risk tolerance.

The second reason that I can think of is managing the portfolio in retirement. A lot of the baby boomers are now in retirement. When you enter that phase, you enter the withdrawal phase of the portfolio instead of the accumulation phase, and at that point, you need regular income every month and then you need the more conservative portfolio allocation, and that means bonds.

Benz: Let's look at international equity. That was another group where we saw very strong inflows. Here though in contrast to taxable bond, you actually saw the lion's share of flows going into passively-managed international equity funds. What's going on there?

Lamy: It's interesting because international equity is a little bit between U.S. equity and taxable bond. Active flows are still positive, but they are much smaller than passive flows. It seems that investors are gravitating the same way as they did from active to passive, from higher cost to lower cost in the realm of international equity as well.

Benz: There, what types of funds are they buying? Are they choosing the big broadly diversified vanilla-type products to the extent that they are buying some of those passively managed international equity funds?

Lamy: Correct. The category with the largest flows is foreign large blend, which is a broad, diversified global, mostly focused on developed and mostly focused on Europe. That makes sense because despite ongoing talk of Brexit and then there was some unrest in Spain, but despite that the forecast still looks good for Europe. The European Commission, I think, they have forecast said that the Eurozone is set to grow with the fastest in the last decade. It seems that investors are chasing those growth prospects and at the same time, diversifying their equity allocations away from the U.S.

Benz: You hinted at the fact that U.S. equity has been an area where investors appear to have completely given up on actively managed products. Let's talk about the flow data for 2017 there.

Lamy: For active U.S. equity, it's not very good, definitely negative. Investors are still reacting to the two main factors that are driving these flows--cost and performance. In terms of cost, they are just reallocating from expensive active to lower-cost passive. In terms of performance in 2017, only about 35% of active U.S. equity managers outperform their benchmarks. That's not very good. That's about a third.

Benz: Right. In terms of category inflows and outflows, one thing that jumped out at me is that large-cap blend is an area where investors continue to add to their holdings, especially to some of the big broadly diversified index products. Large-growth, though, looks to be a category where investors just don't want anything to do with it. That was one of our best-performing categories last year. What do you think is going on?

Lamy: That might be just not such a good timing, and also, investors who are moving into passive tend to shy away from specialized categories from large growth and large value sometimes as well. Investors who go into passive, tend to go blend. The three top categories in passive U.S. equity last year were all blend--large, mid and small. That may be again one of the side effects of that movement to passive.

Benz: Let's talk about the fund family view. In terms of big winners, I guess, people wouldn't be surprised that the firms that are topping the charts--Vanguard and BlackRock, big passive presence on the part of both of those firms.

Lamy: Big passive presence. Vanguard, undisputed leader last year. The interesting phenomenon that happened is that I have a chart in my report with the Vanguard versus the rest of the world. In 2015 and 2016, Vanguard was the only positive one and the rest of the fund industry was negative. Last year, Vanguard was still the larger piece of the pie, but the rest of the fund industry on aggregate was also positive.

Benz: In terms of new inflows?

Lamy: In terms of new inflows.

Benz: A couple of firms seem to have bucked this trend. Even though their lineups skew toward actively managed products, they have actually been seeing decent inflows. I want to talk about those. American Funds as well as PIMCO, a coupe of firms that we had been worried about in terms of outflows just a couple of years ago, appear to have kind of righted the ship.

Lamy: American funds did really well with some of its funds and not so good with others. For example, they had really good inflows to their Balanced Fund and to their American Funds Bond Fund of America. On the other hand, their growth fund suffered.

Benz: Growth Fund of America.

Lamy: Growth Fund of America, speaking of large growth and how investors are running away from that.

For PIMCO, PIMCO recovered really well with PIMCO Income, which was a really good performer after their severe outflows from Total Return. PIMCO Income has the largest inflows, the top fund in the past year. It's been really, really in demand even after they raised fees. They are a really, really good fixed-income performer.

Benz: Alina, always interesting to hear about the intersection between fund flows and investors behavior. Thank you so much for being here.

Lamy: Thank you for having me, Christine.

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