Have Investors Stopped Chasing Returns?

During the late-1990s tech-fueled boom, one of the laws of the asset management industry was that money followed returns. Back then, a new fund--especially one with "technology" in its name--could count on massive inflows after just one or two big years. This was in keeping with the belief that retail mutual fund investors were the "dumb" money and they could be counted on to behave like lemmings.

It appears that fund investors have become less inclined to chase performance in the two decades since, as strong returns within a given category no longer mean retail money will follow. For example, among U.S. equity funds (including both open-end and exchange-traded funds), the large-growth Morningstar Category has by far the best returns over the past five years through late November 2018, with a 10.6% average annualized return. Yet large-growth funds had by far the greatest outflows of any U.S. equity category. Investors pulled an astonishing $241 billion from large-growth funds through October 2018, far more than the other eight domestic categories combined.

Investors instead flocked to large-blend funds, sending $363 billion their way. True, large-blend funds had solid enough performance, gaining 9.1% annualized over the past five years. But that doesn’t explain why many investors apparently ditched large-growth funds for their large-blend counterparts.

Rather than chasing performance, then, fund investors seem to be embracing core strategies, such as large-blend funds, more than ever. Not coincidentally, the large-blend category is home to the big, market-cap-weighted index funds that have become so popular as portfolio building blocks. Over the past 12 months alone, investors have plowed $90 billion into passively managed large-blend funds. The venerable

So, there is undoubtedly a connection between the rise in popularity of low-cost index funds and the apparent decline in performance-chasing. This dynamic shows in other asset classes, too. Look at international-equity funds. Over the past five years, foreign large-blend funds, cousins of U.S. large-blend funds, had among the lowest average returns for international equity funds at just 1.7% annualized. World large-stock funds fared far better—mostly thanks to their U.S. exposure—with a 5.7% average return. Yet, foreign large-blend funds took in an overwhelming $495 billion over the past five years. Meanwhile, world large-stock funds had outflows of nearly $21 billion.

This suggests that investors have become more strategic and less performance-driven when it comes to asset classes, too. The 9.1% five-year average large-blend return trounced the 1.7% earned by the average foreign large-blend fund. Nevertheless, despite this massive gap, foreign large-blend funds still collected $132 billion more than their U.S. large-blend counterparts.

As in the U.S., index funds have led the way in overseas investing. Of the nearly $709 billion that went into international equity funds over the past five years, about $625 billion of it went to passively managed funds.

This push into core strategies extends to bond funds as well. Of the $820 billion that taxable-bond funds collected over the past five years, intermediate-term bond funds claimed $359 billion--that’s $234 billion more than any other category. Of those total taxable bond inflows, about three fourths went to passively managed funds.

Investors acting more strategically than impulsively also shows in the flows to long-government bond funds. Although these funds are down about 7% on average over the past 12 months, they have still collected about $15 billion in new money during that time. Those investing in these funds are likely more focused on the diversification benefits of long-term Treasury bonds than on short-term negative returns.

What's Behind This Shift? Have investors become more enlightened? Perhaps, but nonbehavioral factors can't be ignored either. Much of the flows into core index funds owe to the rise of target-date funds within 401(k) plans and elsewhere, many of which invest heavily in underlying index funds, and other forms of automated investing. Plus, more advisors are using passive funds to build model portfolios for clients. So, while many investors have hopefully learned from performance-chasing mistakes, structural forces are prominent, too, if not predominant.

Is This Really News? To some extent, the popularity of core strategies could simply be called prudent investing and isn't really new. After all, core strategies are what they are, the building blocks for most investors' portfolios. But it's still striking that investors seem less inclined to follow the siren call of eye-popping past returns and take a flier on a tech fund or a single-country emerging-markets fund.

Instead, and for multiple reasons, investors seem to be doing more of what experts having been advocating for years: acknowledging their limitations, embracing low-cost, broadly diversified funds, and not chasing past performance. It’s an encouraging sign.