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U.S. Investors Still Favoring Foreign Fare

Christine Benz
Timothy Strauts

Christine Benz: Hi, I'm Christine Benz for Morningstar. Investors continue to favor international-equity funds in 2015. Joining me to discuss the latest news in the world of fund flows is Tim Strauts--he is a senior markets research analyst with Morningstar.

Tim, thank you so much for being here.

Tim Strauts: Thanks for having me.

Benz: Tim, you and the team have been monitoring these fund flows into international-equity funds. We've seen them outperform U.S. so far in 2015, but this has actually been going on for a while where investors have been choosing foreign funds at the expense of U.S.

Strauts: The trend has been happening for about two and a half years now, and it's only accelerated over the last year. In the last year, a little over $210 billion has flowed into international funds. In the U.S. equity space, we've actually seen an outflow of a little over $10 billion in that same time period, so investors are clearly preferring international right now.

Benz: You think it has something to do with the fact that the investors in U.S. funds are anticipating Fed tightening and thinking that the economic cycle in Europe, in particular, could be more favorable for foreign-fund investors.

Strauts: I think we're kind of in a unique period here. Typically, fund flows follow performance, but that really hasn't happened here because U.S. equities have actually been a better performer than international. But what's happening, I think, is that investors are very skittish about the U.S. bull market. They have never really fully bought in to the performance. They feel that, in some cases, maybe the Fed is manipulating things with the ultralow interest rates. They really just haven't bought in. So, investors have been allocating over the last several years to international because potentially the valuations look a little more attractive.

Benz: When you look at the types of international-equity funds that are getting the flows, where is the money going?

Strauts: It's focused on the index funds right now. The largest-flowing fund is the Vanguard Total International Stock Fund (VGTSX). We have seen, in the past two and a half years, flows into emerging-markets ETFs being strong; that trend has actually switched recently. Now, most of the flows are going to developed international markets and away from emerging.

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Benz: You touched on the problems that we've been seeing with U.S. equity fund flows. The issue has really been concentrated in the active products. Investors are pulling their money there. Many are reallocating to passive products, but it hasn't really been able to make up the money coming out of active funds.

Strauts: In the last year, active U.S. equity has lost $158 billion, and passive U.S. equity has taken in a positive $140 billion. So, they are almost balancing out, but the number is still negative because of the large active outflows.

Benz: One complicating factor--and we probably don't want to get too far into the weeds on it--is that Fidelity has been doing some repositioning within its lineup, especially for retirement-plan investors where it's swapping people out of the traditional mutual funds and putting the money into collective investment trusts. [Are these being managed the same way?]

Strauts: Collective investment trusts are used in 401(k) plans. Fidelity has been doing a lot of that, but many other firms have been doing it also. It's a way, potentially, for a 401(k) provider to get a little bit lower fees, using the same exact strategy. Fidelity has actually disclosed the amount of the conversions over the last year to us. It actually changes Fidelity's numbers by about $14 billion. It's a $14 billion difference in the flows. It makes U.S. equity flows look $14 billion worse. It makes Fidelity's flows look $14 billion worse when, really, they haven't lost that money; they just moved it to a different vehicle.

Benz: Actually, Fidelity's domestic-equity-fund performance has been pretty good during this bull run.

Strauts: Yeah--that's why, for the last several months, we've been questioning some of the outflow numbers because we had been hearing rumors of the conversions. We hadn't actually gotten the data that we got this last month.

Benz: Also, on the fund-flow front, you look at fund flows by family--Fidelity you just touched on. There was an interesting turn of events recently; we had been seeing this gusher of outflows from American Funds for a period of years. They appear to be back in asset-gathering territory. Investors are sending money to American Funds.

Strauts: In the last year, they took in a little over $10 billion in assets. Just last month, it was $1 billion. It's been a slow-and-steady gain after many years of strong outflows. What's interesting about this is that there hasn't been an event that you could point to and say, "This is the reason the flows are coming in." American Funds' performance actually never really fell off that much on a category basis versus their peer group. It just seems as though all the financial advisors who had gotten out of American Funds are finally all gone, and now they can start building back up.

Benz: Another fund-family story that I know you and the team have been monitoring has been the PIMCO story. The big ongoing redemptions from PIMCO Total Return (PTTRX) haven't been fully offset by inflows into another PIMCO product.

Strauts: Total Return lost another $3 billion last month. Previously, we were seeing the flow numbers get a little bit better for Total Return, but in the last three months, it's been about $3 billion each month. So, it has kind of leveled off, and $3 billion is still a substantial amount. So, PIMCO definitely has some things to be worried about. But they have been receiving flows into the PIMCO Income fund (PIMIX)--which is run by Dan Ivascyn, who is also now a co-portfolio manager on the Total Return fund. The thing is, though, that the Income fund has not taken in as much money as Total Return is losing right now.

Benz: Another thing that I've been watching with that PIMCO Income fund is whether or not people understand how much riskier it is than some of the other core bond products.

Strauts: The PIMCO Income fund isn't really directly comparable to Total Return. It has emerging-markets debt; it has a lot of nonagency mortgage securities. It has things that the Total Return fund isn't really going to buy.

Benz: Though, it certainly has an attractive yield, which I suspect is part of the attraction.

Strauts: Yes.

Benz: One fund family that jumped to the top of the asset-gathering rankings in the month of July was a firm called Bridge Builder. Let's talk about that and what those funds are.

Strauts: We saw it this month especially, but it's been going on for the last several months. Initially, I had no idea what Bridge Builder was, but after doing a little bit of research, it looks like it's actually an Edward Jones product for their financial advisors in their advisory accounts. In the past, Edward Jones would have a select list of funds that were available in their advisory accounts, but now it looks like Edward Jones is converting over to moving all of the money to these Bridge Builder funds. The Bridge Builder funds are actually then subadvised by many of the same managers that were on this select list. So, it's a way for Edward Jones to bring everything in-house. So, we're seeing lots of conversions and large inflows into these products, but they are not actually new money. It's just money moving from the original mutual fund to these subadvised funds.

Benz: Tim, thank you so much for being here to share your insights.

Strauts: Thanks for having me.

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