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Positive Signs for Investor Behavior in Flows Data

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Investors seem to be taking a contrarian tack with some of their recent mutual fund purchases. I recently interviewed Fran Kinniry, principal in Vanguard's Investment Strategy Group, to get his take on that trend and how likely it is to persist.

Fran, you and your team have created these risk speedometers. Let's talk about what they are and what you are trying to capture with them.

Fran Kinniry: We've been tracking investor behavior or investor cash flow for a very long time. We follow the work that Morningstar does, and you do a great job on the IRR, which is the internal rate of return, which is the investors' return versus the time-weighted return. We do our own calculations. We've been doing that since I have been here, which is over 20 years. It's part of Vanguard's advisors' alpha work on behavioral coaching. We've been always studying what investors are doing and now we are publicly commenting on that, what we are seeing, what are the trends that help investors and advisors think about what their peers are doing and what investors in general are doing. It's really a readout of what's happening and then putting that into a historical concept.

Benz: Let's talk about some of the trends that you've been observing. One I want to hit on with you is this idea of the flows into international equity funds appear to have predated the better relative performance in international equity funds. It almost seems that investors were taking a little bit of a contrarian tack when approaching their international exposure. Is that something that you find when you look at the Vanguard data on this topic?

Kinniry: Absolutely. What we have seen is, as far back as we have records for, investors were momentum-based, meaning that they followed returns, there was positive cash flow typically to the three-year, five-year winners. A momentum-type theme would be pretty consistent up until around the last five to seven years.

I'm not sure if it's contrarian. Our hypothesis is--and it's just a hypothesis at this point because time will tell, time proves a lot of these hypotheses to be wrong--but our hypothesis is, a couple of things have happened. The target retirement funds, where you set an asset allocation and you are rebalanced to it; the model of advisors going to fee-based of developing a portfolio and rebalancing to it. Let's think about a top-down approach where we set an investment policy, rebalance to it. The more investors or dollars that are doing that, it would look like a contrarian cash flow, because you are rebalancing. And so, you think about, international flows have been very, very strong for the last five years and the five-year performance looks very weak …

Benz: Relative to the U.S. market.

Kinniry: … relative to the U.S. I can show other categories, our large-cap growth has been one of the top-performing asset classes over the last five and 10 years getting hardly any flow. The cash flows do look like an asset allocator's cash flow and that to us is great news. It's how a professional would invest money as opposed to someone chasing returns.

Benz: Would you say the same is true of the flows that we've seen into bond funds recently, even though bonds, they haven't performed terribly, but certainly relative to equities, performance has been poor. What's going on there?

Kinniry: In the late 90s, you saw the bull market of the late 90s and a 100% of flow into equities, selling bonds. This is actually healthy, right? If stocks are in a nine-year bull market, hitting new highs every day, you want big cash flows into bonds, especially relative to stocks. We see that as very, very healthy behavior.

Now, again, why it's a hypothesis is, we have to see. If the market experiences a decline of, let's say, a bear market of 20% or 30%, if investors are buying stocks in that environment, that would really be a change. Or do they go back to following returns of selling stocks at the bottom. Time remains to be seen. But the last five to six, seven years really looks like what we would call an asset allocator's cash flow instead of a fundpicker's cash flow.

Benz: We just talked about how flows into bond funds have actually been quite robust. But is it your sense just sort of speaking as an investor that some investors are complacent about risk in their portfolios and maybe have been a little bit reticent to take risk off the table in their portfolios given that the bull market has been so very long running?

Kinniry: I would say it's a great news-not so great news story. The great news is the cash flow is contrarian to the markets, meaning investors are showing a rebalancing propensity, which is the good news side, very different than we saw in the late 90s, through the bear market, the melt up of '07 and the decline of '09 where cash flows were all momentum-based, buying the winners. Let's applaud investors for doing that well.

What you may want to see is, is the amplification enough, should it even be more into bonds and less into stocks because we are hitting new all-time highs on the stock market. The stock market has been up so dominant relative to the bond market. That's probably a lot to ask for. We will take the fact that at least investors are not doubling down on the equity market here and are at least showing a cash flow that looks very balanced.

Benz: OK, Fran. Really interesting research. Thank you so much for being here to discuss investor behavior with us.

Kinniry: Thank you, Christine.