PMC Weekly Review - August 18, 2017
For the first seven months of the year, the domestic equity indices, and most of the international indices as well, have steadily marched higher, while the taxable and municipal markets have churned out better-than-expected returns, too. Volatility has been consistently low, and outside of a few short-lived exceptions, there has been very little “fear” in the markets so far this year. With positive returns in nearly every corner of the financial markets and no significant events to drive the average investor out of a particular asset class, what can we glean about the average investor’s mindset by reviewing the mutual fund flows over the last seven months? We looked at Morningstar’s estimated fund flows for actively managed funds in the 40 largest categories (out of 110) to find out. Understanding that every individual investor has varying needs and objectives, there were a few trends that stuck out.
Fixed Income is king. By percentage (year-to-date (YTD) flows/2016 year-end assets under management (AUM)), nine of the top ten categories for inflows are fixed income, with international large core the only exception. Even by gross dollar flows, seven of the top ten are fixed income (international large core, US large core, and emerging markets equity). Within fixed income, two trends stand out: fear of rising rates and the search for yield. The top two categories by percentage inflows were ultrashort bond (19%) and bank loans (14%), both traditional categories for avoiding price depreciation in a rising rate environment. Also among the top ten were non-traditional bond funds, many of which attempt to reduce or eliminate the interest rate sensitivity of their portfolios through various hedging techniques. The search for yield can be seen in the inflows to multi-sector bond, world bond, high yield municipal bond, and emerging markets bond funds, ranked third, fourth, sixth, and seventh, respectively. Not surprisingly, intermediate government bond funds, with some of the lowest yields and higher sensitivity to interest rate changes, were one of two fixed income categories to have outflows. The other fixed income category that had outflows is surprising: High yield bond funds had $12.5 billion in outflows, or nearly 5%.
Simple exposure to equity markets is heavily preferred. Investors continue to pile into large core funds, both domestic and international, to gain simple exposure to equity market “beta,” particularly cheaper passive exposure. Active US large core funds had $30.6 billion in inflows so far this year, or growth of about 1.5%. Passive funds and ETFs in the same large core space took in more than three times as many new dollars, more than $94 billion or just over 5%. A similar theme prevails in the non-US markets, as active foreign large core funds took in just over $40 billion (6% growth) so far this year, while their passive counterparts took in nearly $81 billion (15% growth).
Other domestic equity, despite the performance YTD, is shunned. The record-setting performance of the major domestic equity market indices has not proven to be the usual huge draw for the average investor, other than the aforementioned large cap core space. Only one of the remaining eight domestic equity categories, midcap core ($2.2 billion), showed positive flows in the first seven months of the year. The other seven categories had a total of $77 billion in outflows, dominated by large growth ($37 billion) and large value ($25 billion). Outflows from large growth funds are particularly surprising, given the Russell 1000 Growth Index’s return of more than 17% through the end of July. Some of this is surely rebalancing, as equities continue to outperform.
We thought the trend of investors shifting from active to passive management may explain some of the flow, but it turns out to be a relatively small percentage. We reviewed the flows to passively managed mutual funds and exchange-traded funds (ETFs), and all nine domestic equity styles had positive flows. But passive large growth flows totaled just $11.5 billion, and large value flows were $13.7 billion, leaving both categories well into negative territory. In fact, ex-large core, domestic equity funds, both active and passive, had net outflows of nearly $28 billion.
One very general conclusion can be derived from reviewing the mutual fund flows so far this year: Investors are making more active allocations with their fixed income investments, searching for more stability or more income, while being less active with their domestic and international equity holdings.