Cash Flow Trends Mark Changing Investor Behavior

Christine Benz: Hi, I'm Christine Benz for Morningstar. Much academic research centers around investors' tendency to buy low and sell high, but recent data point to a more contrarian pattern. Joining me to discuss cash flow trends into various asset classes, and whether they suggest a lasting change in investor behavior, is Fran Kinniry. He's the Global Head of Portfolio Construction in Vanguard's Investment Strategy Group.

Fran, thank you so much for being here.

Fran Kinniry: Thanks, Christine. Good to see you.

Benz: Good to see you, too. So, we have talked on and off over the past few years about some of these contrarian patterns where we're not seeing the same performance chasing that we had seen maybe a decade ago in investors. So, let's talk about that, what you see when you survey the data. How are investors making their choices among asset classes? And do you see performance-chasing, or do you see a more contrarian pattern?

Kinniry: Yeah, so as part of my role at Vanguard studying investor behavior through our Advisor's Alpha research team, it's been pretty incredible and pretty stark the contrast that we've seen, let's say, in the last five to seven years, relative to all of history. Throughout most of time, we saw what we would say trend following, or investors buying whatever had been positive over the last three and five years. So, the best-performing asset classes getting the highest flow, the worst getting the most negative flow. About five, six, seven years ago, we started seeing a contrarian behavior, which would be selling the assets that had the best performance, buying the assets that had the worst performance, which would really be countercyclical, very different from the past and almost mimic what would be rebalancing. So, we were very optimistic, but we've been watching this very closely for several years to see how this would play out, but the early signs are, it's a very, very good sign for investor outcomes.

Benz: So, when you look at those flows, more recently, bonds have actually been getting a good amount of attention. Bond returns in 2019 have been great. But certainly, bonds have not been as strong over the past five years as equities have been. So, bonds, international equities, what other themes do you pick up on?

Kinniry: So, just in 2019, you see over $200 billion into fixed income and negative flows into equities. And so, when you look at that, when you say, well, the equity returns, we're in one of the longest and largest bull markets ever. And so, you would think normally that would be reversed. So, what we're seeing is investors buying what we would say more conservative asset classes, fixed income, money market, coming out of some of the high-risk assets that have done very, very well over the last decade, and the last 12 months.

Benz: So, large growth, for example, which has been a great category for several years running. That's been a category where really you've been seeing investors pull their funds.

Kinniry: Yeah, it's interesting. So, if you go into the sub-sectors, the top performing asset classes or sub-asset classes have some of the biggest redemptions. And a lot of people originally thought this was substitution, meaning selling out of high-cost active and going into ETFs. We're not actually seeing this substitution, because if you were to think of it from a substitution, you would see negative flow from, let's say, large-cap mutual funds on the growth side, but heavy flows on the ETFs. We're not actually seeing that. We're seeing selling large-cap growth, buying fixed income. And so, we're seeing a much more rebalancing-type portfolio to that.

Benz: So, the fourth quarter of 2018, people will remember, that was a bad environment. Did you see any reversal because a lot of the period that we've been talking about has been really quite a strong equity market. Did you see people doing anything different?

Kinniry: Yeah, and that's why we're leaving it as a hypothesis because we have been in this almost secular bull market, but we are looking at sub-periods, the fourth quarter, or the last six weeks of 2018, the stock market lost 20%. And once again, we actually saw countercyclical behavior, meaning that investors bought equities in that environment. So, our conclusion is, investors are following a policy portfolio. Whether they're doing it through an embedded solution like a target retirement fund, or they're actually seeking advice an advice value proposition that's more about getting an asset allocation and rebalancing to it, that's the behavior we're seeing, which is all great news for end investors.

Benz: So, by policy portfolio, you mean sort of a long-term strategic asset allocation plan that I'm periodically maybe rebalancing back to, and that would explain the preference for bonds amid a strong equity market?

Kinniry: That's exactly right. So, hypothetically, if you're 60% equity, 40% bonds, and you are equal between growth and value, explains a lot of the behavior we would see, out of growth, out of equities into bonds. And so, having an asset allocation and rebalancing to that, that's what the cash flow looks like. And it's one of the first times we have seen that type of cash flow, at least since we've been looking at it over the last 20-plus years.

Benz: OK. So, all good trends, but you'd want to see kind of a complete market cycle, is that right, to be able to draw any real conclusions about whether this is maybe a lasting change?

Kinniry: Absolutely. We want to see a complete market cycle. Even in 2008 and 2009, one of the worst bear markets, we did see good behavior in target retirement funds and in people that were kind of advised in this way. So, what our conclusion is, is more and more of the market has gone from fund-pickers, you know, building it bottom-up, to more strategic, you know, I'm going to build it from the top-down, asset allocation, sub-asset allocation, rebalance to it. If that is the case, then this is a really good situation for end investors because their cash flows are countercyclical and they're following their policy portfolio.

Benz: Fran, always great to get your perspective. Thanks so much for being here.

Kinniry: Thank you, Christine.

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