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Surprise Outflows for Passive Equity Funds

Two funds contributed the lion's share of passive outflows over the past two months.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors continue to pull money from U.S. stock funds, and lately the redemptions have extended to passively managed funds. Joining me to discuss the latest fund flow data is Kevin McDevitt. He's a senior analyst in Morningstar's manager research group. He's joining me via Skype today. 

Kevin, thank you so much for being here.

Kevin McDevitt: Thanks for having me, Christine.

Benz: Kevin, let's start with what we have seen in terms of U.S. equity fund flows. We've seen significant redemptions going on for a while now, but recently we have started to see investors pull money from some of the index products. What do you think is causing investors to pull away from U.S. stock funds, including the index products?

McDevitt: As you noted, the really surprising thing is that you are seeing some passive outflows. This was actually the second consecutive month of passive U.S. equity outflows. We haven't seen that since the fall of 2009, if you can believe it, so it's been a really long time. Because as you noted, we've had such strong flows of money moving from active equity funds, active U.S. equity funds to passive funds, but now, again we're seeing outflows within the passive U.S. equity space.

The frustrating answer I think is that I don't know if we can really assign any judgment as to what the trend is here, because I think at this point, it's still fairly anecdotal. To kind of put something behind that, you really only saw big outflows out of two passive funds last month, two S&P 500 ETF funds. That was the iShares core S&P 500 fund and the SPDR S&P 500 fund. It was really those two funds that almost by themselves, they kind form the lion's share of passive outflows.

Between just those two funds, you have about $25 billion in outflows. What's interesting, there is even among other S&P 500 index funds, you actually saw inflows. The Vanguard S&P 500 fund, Fidelity's S&P 500 fund, both saw modest inflows last month. Really it's just those two funds. That makes it all seem so anecdotal even though it's noteworthy and something we want to pay attention to, but it's hard to really draw general conclusions because we didn't see that level of outflows across the board.

Benz: Certainly we've had some equity market volatility that may be responsible for investors pulling money from the asset class altogether, but as you say, at least on the passive side it's highly concentrated in just a couple of S&P 500 funds.

McDevitt: I would also note, too, that those funds tend to be used in a lot of asset allocation plans. They tend to be used by institutions and by traders. My point being of all these different segments, investor segments owning those funds, and they might be moving money around for any number of reasons. It could be driven, and likely I'm sure to your point, it is driven somewhat by market volatility, but there could be other things going on there, too. It could be, again, investors reallocating portfolios, rebalancing, trading, doing any number of things. Just as somewhat of a counterpoint, too, I think it's noteworthy is that we're seeing these outflows of passive flows the past two months, and there has been equity market volatility, but these outflows are actually even greater than what we saw during the last correction in 2015, 2016. The market fell quite a bit more, at least up to this point. That so far was a more robust correction than what we've seen so far this year. Again, I think it's noteworthy that we've seen greater outflows this year than we did during the last correction. 

Benz: Moving on to foreign stock funds. They've experienced volatility so far in 2018, too, but they've actually been seeing positive flows primarily on the passively managed side. Let's talk about the types of funds that have getting inflows among foreign stock funds.

McDevitt: You still saw flows into foreign large-blend funds and emerging-markets funds. Diversified emerging-markets funds are still seeing strong flows in. To your point, too, you're seeing some volatility there, but I think that market, the foreign equity market is not--from a U.S. investor's standpoint--that market is not as mature in terms of that trend of money moving from active to passive. I feel like that is still playing out, perhaps that secular shift from active funds to passive. Then also, again, you certainly have had volatility in foreign markets, but maybe not to quite the same degree or as much across the board as you've seen in the U.S.

For example, in the first quarter, you still has emerging-market funds up about 2% or so. Again, nothing fantastic, but certainly not a poor result and not enough to necessarily break the trend or break momentum of investors moving money to those funds.

Benz: Carrying on with the various asset classes. Bond funds continue to see significant new inflows. Obviously there are lots of moving parts here, lots of reasons investors might be buying, but can you talk about what you've been seeing in the realm of bond funds? Also, can you address what you've been seeing in terms of the active versus passive breakdown? Here, it appears that investors are keeping the faith in active management to some extent.

McDevitt: For what it's worth, the research, at least the research we've done, backs them up on that. That's the fact that on the fixed-income side, actively managed funds, especially if you're talking about more credit-oriented, lower liquidity, subasset classes within fixed income, active mangers have done fairly well there, and in many cases better than passively managed funds, than index funds. There's a real rationale for investors to be considering low-cost actively managed fixed-income funds. More from the asset class standpoint or what's happening on the category level. At least in the first quarter, the demand was for more core products. Intermediate term bond funds saw the strongest inflows. Ultrashort bond funds also saw very strong inflows.

If anything, I think that's where you saw an investor response to equity market volatility. That perhaps investors are moving more money from their equity funds to fixed-income funds. Again, the fact that they were buying intermediate term bond, ultrashort-term bond, and then also we saw outflows, redemptions, net outflows from high-yield bond funds. I believe that was for sixth consecutive month that we've had outflows from high-yield bond funds.

Benz: In terms of flows, it does appear that a lot flows these days are driven by some sort of professional manager, whether a financial advisor or an institution. Do you think that simply rebalancing has prompted some of the flows that we've seen into taxable bond funds, where investors are stripping away from the appreciated equity positions and perhaps adding to fixed income given how long this equity market rally has been going on?

McDevitt: Absolutely. I wonder, too, if interest rates might play somewhat of a role there, too. That fact that ultrashort-term bond inflows were strong. Perhaps as rates have gone up, yields have gotten better for those funds. Perhaps that's a mild factor as well, but certainly I think rebalancing is playing a big role. It could be investor risk aversion as well. I think that factors in there, too.

Benz: In terms of fund flows, we typically talk about which funds families are seeing the biggest inflows. One thing that you noted in your recent fund flows report, Kevin, was that Vanguard has been gaining share at the expense of iShares and State Street. What's going on there? Is it simply price wars, or why is Vanguard gaining assets at the expense of some of its other competitors?

McDevitt: I would say it's State Street in particular, for what that's worth. I think it is just as you said, I think a lot of that is just simply costs. If you look at for example, the S&P SPDR fund, its expense ratio is 9 basis points for iShares S&P 500, and for Vanguard's S&P 500 ETF, it's 4 basis points. I think cost is certainly a part of that. I think also, too, you're still seeing momentum in terms of--Vanguard's products perhaps are not being used as much as much on the trading side, and I don't know if there's a rationale for that. Again, it's striking to me that you saw huge flows out of iShares and the SPDR S&P 500's funds, but you didn't see that from Vanguard. I wonder--and this again, I think it's something that we want to look into more--I wonder if even though they all trade the same way, if investors are treating Vanguard's ETFs differently, or different types of investors are owning them. Again, that's something we need to follow up on in the months to come.

Benz: Kevin, thank you so much for being here to discuss the latest fund flow data.

McDevitt: Thank you, Christine.

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