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Index Funds Clean Up (Again) in 2014

Christine Benz
Timothy Strauts

Christine Benz: Hi, I'm Christine Benz for Morningstar. Investors continued to demonstrate a strong preference for passively managed products in 2014. Joining me to discuss this phenomenon is Tim Strauts. He's a senior markets research analyst for Morningstar. Tim, thank you so much for being here.

Tim Strauts: Thanks for having me.

Benz: So, Tim, when you look at the headlines in terms of what fund categories investors were buying in 2014, it was a decent equity market, so probably not surprising that investors were putting money into equity funds.

Strauts: The biggest categories for flows into equities were large blend and foreign large blend, and that's not because investors love blend funds. It's primarily because they are moving toward index funds. The major index funds fall into the blend category.

Benz: Another category that we've been monitoring has been emerging markets. Investors have ebbed and flowed in terms of their flows into emerging markets. Let's talk about what you're seeing there.

Strauts: It was one of the biggest outflows this last month, obviously, because of the drop in oil prices and the Russia situation and some weakness in China. Emerging-markets returns have not been as good, so investors are rightly concerned. And also a factor is the rise in the U.S. dollar, which makes returns in emerging-markets currencies less attractive. But over the year, emerging markets still were positive with a total of about $12 billion in inflows. Just in the last, say, three to four months, we've seen large outflows in the category.

Benz: When you look at the biggest losers in terms of asset outflows, taxable bond, in terms of asset classes, you say leads the way and you say that that's driven mainly by big outflows at PIMCO Total Return (PTTRX) and other PIMCO products.

Strauts: On the active side, we saw $23 billion in outflows out of taxable bond, and that is almost 100% coming from PIMCO Total Return--the large outflows. And flows out of the fund, PIMCO Total Return, were negative $18.1 billion last month, which is kind of a worrying sign because we were seeing improvement in the flows out of Total Return; but this month, we actually saw acceleration. So, in November, it was only a $10 billion outflow and now we've accelerated to $18 billion.

So, some investors clearly were reallocating their portfolios at the end of the year. And actually, we see that PIMCO showed us the daily flows out of the fund, and on the last day of the year, there was a big spike in outflows. Clearly, people wanted to have their portfolios reallocated for the first of the year.

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Benz: Any indication about whether that might have an impact on how the fund is positioned? Are they holding a lot of cash to meet redemptions?

Strauts: So far, they have done a very good job of managing all of these massive redemptions. They have a lot of Treasuries in the portfolio; they have been able to sell out of a lot of their less liquid positions like [emerging-markets] debt. And frankly, their use of derivatives, which some people don't like, has actually helped them during this period, because it is much easier to sell their derivative position than it is to sell an illiquid bond of Russia.

Benz: So, that's helped them meet redemptions. Let's talk about where those flows have been going if investors have been pulling money from PIMCO Total Return. Which fund companies and which specific funds have been getting the assets?

Strauts: So, I think there are three clear winners at this point that we've seen. [One is] Metropolitan West Total Return Bond (MWTRX), which had an inflow of over $7 billion last month. Then, Dodge & Cox Income (DODIX), which had an inflow of about $2 billion. And then, Vanguard Total Bond Market Index (VBMFX), which had a $4 billion inflow.

Over the last three months, these three funds have consistently been in the top-flowing funds. So, they are clearly getting many of the Total Return assets.

Benz: So, it's not necessarily that investors are saying, "I don't want core-bond exposure." They just want it at these other places.

Strauts: Yes, that is definitely true. But what I would say is that not all the money is going back into core bond. A lot of it is maybe reallocating to different bond categories--or even equities.

Benz: So, a few bond categories you noted investors seem to be in risk-off mode when they're looking at their fixed-income stakes: High-yield and bank-loan investments did see outflows.

Strauts: High-yield and bank loan, over the last few years, have been two of the top-performing flow categories, I'd say. Just last month, high-yield lost another $9 billion in assets and bank loan lost about $7 billion. So, investors are clearly seeing that credit spreads have risen, which has hurt returns. People are feeling there is a little more risk out in the world. And with low interest rates, people are avoiding the riskier bond categories.

Benz: In terms of fund-family flows, we've talked about PIMCO. Let's talk about another firm that we have been watching for these past few years because it had seen such big outflows. American Funds--how are they doing?

Strauts: So, American Funds has stemmed the tide of outflows. They actually, for the year, had a slight inflow of $300 million--which is, I think, a very good sign, considering the large outflows they were seeing over, say, the last five years. So, it's good news on the American Funds front.

Benz: And Vanguard, you've touched on that they seem to be winning these fund-flows sweepstakes the past few years. I think one interesting thing is that, in addition to the passively managed flows, you also note that their active funds have actually seen pretty good inflows as well.

Strauts: People think Vanguard is a passive shop; but actually, they have a very large active business, and they had $18 billion in positive flows in their active category, which is actually the second-highest for all active firms. So, they are doing a good job in active, which tells you that investors will buy active funds, but they like them if they are cheaper.

Benz: Another firm with a pretty robust active lineup that has been seeing good inflows is JPMorgan. Let's talk about what's going on there and why you think that they have been seeing pretty good inflows into some of these products.

Strauts: So, JPMorgan had positive flows of about $28 billion for the year, which is pretty impressive for a firm like that. So, I think the reasons [for these inflows] are that, obviously, they have done good outreach in marketing to the advisor forces and they also have a captive advisor network in their bank channel. The bank advisors aren't required to buy JPMorgan funds, but they are clearly preferring JPMorgan to other shops when they make investment decisions for their clients.

Benz: So, we've been monitoring flows into passively managed products for a few years now. They've been very, very robust. Let's take a step back and talk about what you think are the major catalysts for this phenomenon.

Strauts: There are a few factors. I think the number one factor is fees. Investors are seeing that there are so many low-cost products today. The lineup has really changed in the last few years--where it used to be that, yes, you could buy an S&P 500 Index fund, but that was pretty much it. But now, you can buy index funds and bank loans; you can buy high-yield bond index funds. So, your choices as an investor for index funds have greatly expanded. And the returns of these index funds--which people had said for a while that you can't index some of these less-liquid areas of the market--the index providers have shown they actually can do it. So, investors are flocking toward index products.

Benz: And as it happened, 2014 was a pretty good year for some of the big, widely owned--especially equity--index products.

Strauts: The major indexes had phenomenal performance. The S&P 500 had a great year. So, anytime you see a really strong year in these indexes, money is going to flow toward the passive side.

Benz: So, some of these flows are driven by individual investors making their own decisions. But advisors also have a growing share of the pie, and they seem to be preferring some of these passively managed products as well. Let's talk about what's driving advisors to embrace passive products.

Strauts: So, as advisors have shifted their business from more of a commission model where they are selling a fund to more of an advisory model where they charge a fee for assets under management, the passive products become more attractive. Because if I'm trying to charge, for example, a 1% fee as an advisor, and if I'm also in that account selling a fund that has a 1% fee-- so it's a 2% total fee--that can be a little bit harder for the clients to stomach, especially if I'm looking at bond funds where the yield may only be 2%.

Benz: Right.

Strauts: So, if I can offer an index product where the fee is only 0.2%, then it's a much easier selling point to my clients to say they're only at 1.2%.

Benz: Is it also an issue that some advisors are held to a fiduciary standard and, therefore, it's easier for them to defend putting clients in cheap passively managed products because they are, in many cases, maybe the best option for those clients?

Strauts: I think that's part of it. I've heard that a lot as a reason, but I have not seen any pressure on advisors to not sell active funds--that somehow active funds are against the fiduciary standard. I think a bad active fund maybe [would be]. But a good-performing active fund will definitely qualify into the standard also.

Benz: Tim, thank you so much for being here to discuss this important topic.

Strauts: Thanks for having me.

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