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Passive Equity Funds Join the Selling Party

The first half of the year saw significant outflows from passive funds in successive months.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors have been selling equity funds, and this time around active equity funds aren't the only casualties. Joining me to discuss the latest trends in fund flows is senior analyst Kevin McDevitt.

Kevin, thank you so much for being here.

Kevin McDevitt: Thanks for having me, Christine.

Benz: Kevin, let's look at the headline where we have seen fairly dramatic outflows from equity funds. The interesting thing is that we have actually seen some selling among passive funds this time around.

McDevitt: Yeah, that's right. I don't want to overstate it, but you did have outflows of about $3.4 billion last month, and overall U.S. equity outflows were about $21 billion or so. It was notable that you had--and the lion's share of outflows came from active funds, but a portion of that was passive. I think what's really interesting is, through the first half of the year in three out of those six months you had outflows from passive U.S. equity funds. That hasn't happened in years and years. It's been at least five years and perhaps we've never really seen anything quite like that where we've seen pretty significant outflows from passive funds in successive months.

Benz: Among U.S. equity funds would you say the selling was fairly indiscriminate, that investors were selling equity funds of all types?

McDevitt: On the passive side, you saw the greatest selling from core holdings, core S&P 500 index funds, some total market funds, really kind of the stalwarts of the U.S. equity passive group. While you actually did see a fair amount of inflows from smaller, perhaps more satellite-type funds, small-cap funds in particular, small blend, small growth all saw actually net inflows last month. It's more of those, kind of, core large blend funds that saw the outflows at least on the passive side. 

On the active side, it's more across the board. Again, with active U.S. equity funds last month, you saw outflows of more than $17 billion, and that was more across the board. Large-growth, we continue to see outflows. Really, large-cap funds of all stripes saw outflows, large value.

Benz: One thing we had been watching, Kevin, was the fact that international equity fund flows had remained pretty robust over the past several years. But it looks like there's even been a little softness there recently?

McDevitt: It's primarily come from emerging markets where last quarter or so emerging-markets equity funds are down about 8% with all the volatility there plus a strong dollar. That finally has resulted in pulling money from those types of funds. You had about $8 billion leave emerging-market equity funds last month and that had an impact on overall international equity flows, too, which were among the lowest you've seen over the past decade. But year to date still international equity flows have been quite strong, over $80 billion or so. That's somewhat curious because overall emerging markets, it's not just because of emerging markets but international markets are down about 3.7% or so depending on which index you are looking at. Inflows have still been strong, especially in the core like foreign large-blend funds, those flows remained strong versus again just contrasting that with the U.S. side, where you've had outflows of more than $20 billion year to date, even when the S&P was up about 2.7% through June. There has been volatility there but nothing like what we've seen in international markets.

Benz: In terms of what investors are doing with their dollars, where they are putting money, funds flows into bonds actually appear quite strong year to date. Let's talk about that. I'd like to hit on the active versus passive divide in fixed income, as well as what types of bond funds investors seem to be choosing, so what categories?

McDevitt: If you look at overall taxable bond funds, you've seen strong flows there year to date over $125 billion or so. In terms of the active/passive divide, it certainly is there just not nearly as pronounced as it is on the equity side. You've seen passive flows of about $70 billion and active flows of about $55 billion. You've seen a bit of an advantage for passive, but again, nothing like what you see on the equity side. 

In terms of individual categories, it's very much core, fairly conservative categories. The top category year to date has been intermediate-term bond with a little over $40 billion in inflows. But that's followed by ultrashort-term bond funds which have seen a little over $30 billion in inflows. That's been really curious to see because it really shows, in my mind, does show a shift of investor preferences in terms of risk appetite. That really started about two-and-a-half years ago when you had a sell-off in high-yield bond funds. Ever since then you have seen declined demand for high-yield bond and increasing demand for ultrashort-term bond funds as the Fed has been raising rates. So, for the year to date, you have seen about $30 billion or so in inflows for ultrashort-term bond funds and about $22 billion, $23 billion or so in outflows for high-yield.

Benz: How about the fund flows among fund families? Vanguard and iShares have been huge beneficiaries as we've seen this enormous torrent of assets going into passive products. It seems like they have both experienced a little bit of softness recently?

McDevitt: They have and it's really across the board and I think it's more indicative of just how demand is slowing for long-term assets in general. Certainly, iShares, BlackRock and then Vanguard, as you said, Vanguard is well behind where it was in recent years in terms of first half flows. I believe this past month was its weakest month since August of 2013 in terms of inflows. You can't really point to any one category or any one asset class. Although, with Vanguard, they have seen net outflows from their active funds this year, active equity funds in particular. But really, that hasn't been the engine for them anyway. It just seems slowing demand, I think, really across the board. It's hard to really chalk it up to an individual family or an individual active versus passive. It's really just slowing demand across the board. I think, again, it's a good thing to keep in mind that this first half was the worst first half for long-term flows since 2015 and the third worst over the last decade. Really, it's really been an across-the-board phenomenon.

Benz: One broad last question for you, Kevin, is the fact that when you sort of look at these fund flow trends in aggregate, I think you see that investors appear to be being a little more pre-emptive in terms of some of their trades that they are not necessarily driving with the rear view mirror as we've so often seen in the past. What do you think--and it's hard to summarize what investors might be doing in aggregate--but what do you think is driving investors to be a little bit contrarian in their choices?

McDevitt: It seems like they are being certainly far more, I don't know if the word is proactive but far more active at least with what they are doing with ETFs in particular. We are seeing big shifts month to month in flows in and out of kind of those core ETF funds. Again, I'm imagining like some of the iShares funds, some of the S&P-related ETFs, you are seeing big shifts month to month. It just suggests that whoever is controlling those allocations has been far more active, whether that's advisors or quantitative investors being model-driven or whatever it is, they just seem to be far more proactive, but also far more risk-averse. Again, it's surprising how much money is going out of U.S. equity funds even though it's nothing like, at least so far, what we saw during the 2015-2016 correction or 2011 or even the credit crisis going back to 2009. It just seems like investors are much more aggressive in kind of tweaking and changing their asset allocations month to month.

Benz: Interesting stuff. Kevin, it's always great to get your perspective. Thank you so much for being here.

McDevitt: Great. Thank you, Christine.

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