Investors Steer Clear of Risk in 2011

Benz: So Kevin, the industry overall had a pretty weak year with just about $55 billion flowing into long-term mutual funds. Investors were buying some areas, but obviously selling some others. What were the hardest-hit spots?

McDevitt: By far the biggest disappointment or the hardest-hit area was U.S. stock funds. U.S. stock funds had nearly $99 billion in outflows for the year, which was not that far behind what we saw in 2008, which of course was the worst of the financial crisis. In 2008, you had about $121 billion in outflows, but again, considering that the market was just flat this past year, albeit with lot of volatility, with a nasty correction thrown in, too, you still though had about $99 billion in outflows in a year, in which the S&P was up 2%.

Benz: Right. So, was the selling broad-based would you say, Kevin, or was it coming out of certain types of funds within the U.S. equity space?

McDevitt: Throughout the year we saw really heavy selling in the large-cap categories, and large-cap growth in particular saw the heaviest selling, pretty much wire to wire. You saw the greatest selling there, particularly funds like American Funds' Growth Fund of America, and to put into perspective, Growth Fund of America had about $33 billion in outflows by itself for the year. And to give you an idea just of the magnitude, that's more than any other fund family had for the year. Fidelity came in second with about $28 billion or so in outflows. So, again, that just puts that in perspective. But outside of large-cap funds generally, as the year went on, you didn't see as much selling out of the small- and mid-cap categories early on. But as things went on, as the year progressed, you started to see more selling in those small- and mid-cap categories, too, so that by the end of the year, it really was very broad-based across all categories.

Benz: Of course performance was also worse in the small- and mid-cap categories in general, in 2011?

McDevitt: Right. Certainly in the second half of the year.

Benz: Kevin, I would like to focus a little bit on international funds. The group did have some modestly positive inflows, but you observed a real dichotomy there, with assets flowing out of developed-markets funds, and into developing markets. What's your take on why that happened, given that emerging markets weren't all that great or were in fact very weak in 2011?

McDevitt: Well, it raises the question of how much performance does actually influence investor behavior. And I think that, investors do still respond to returns, but what we see here is that there is very much of a lag. To spell it out, for the year, you had inflows into diversified emerging-markets equity funds of about $20 billion. Very strong inflows, even though that was by far the hardest-hit category last year; I believe the average diversified emerging-markets fund lost close to 20%. On the flip side of that, the most redeemed category among international-stock funds was in world-stock funds, which actually had the best relative returns, due in large part to their fairly healthy U.S. stake that most of those funds have. But again, it was interesting that as you said, you saw the most extreme outflows, the most extreme negative set coming for world-stock funds.

Benz: So you think, either investors are buying into the long-term growth story of developing markets, or maybe they are looking at the three- and five-year view and seeing the robust returns, probably one or the other scenarios figuring into why investors continue to put money in emerging markets?

McDevitt: Right, I think it is a bit of both. I think it's just the strength and the endurance of the emerging-markets story, and just wanting to diversify outside the U.S., looking for areas where there might be some growth going forward. Then as you said, surely returns for emerging-markets equity funds are still very strong, if you are looking out, five to 10 years in particular. So I think that it would be interesting to see how things shake out in 2012, if investors will continue to put money into emerging-markets funds. Also that said, you did see a bit of a drop-off these last few months in emerging-markets-stock fund flows. For the first time in a long time, they were below $1 billion this past month, in December. So you are seeing declining interest, or at least declining positive sentiment, and it'd be interesting to see if that continues, if you eventually see outflows even perhaps in emerging-markets-stock funds.

Benz: Kevin, I would like to shift gears and talk about a more positive story for the industry. Whereas investors have been dumping equity funds, they were buying bond funds, and taxable bond funds in particular were the biggest beneficiaries in terms of new assets. Can you shed any light on what particular categories were garnering new inflows during the year?

McDevitt: You saw again, a kind of interesting shift happening in the fixed-income categories, similar in a way to what you saw with U.S. stock funds too. In the first half of the year, you saw greater inflows into kind of the credit range, into higher-risk categories. As the year went on, I think investors became more risk-averse, given all the uncertainty in Europe and even the uncertainty in the U.S., you saw investors shifting to the more conservative categories. So for the year, and certainly in the second half of the year, the big beneficiary on the taxable side was the intermediate-term bond category, which was kind of the core buying category for most investors. And in December again, that category led the way and had the strongest flows, I believe at about $6 billion or $7 billion for the category in December.

You also saw the related categories doing well. Short-term bond funds tend to see pretty good flows. One interesting area though is you actually started to see positive inflows into the government-oriented funds, into intermediate-term government funds, an area which had not seen any interest at all early in the year. But as Treasuries rallied throughout the year, you finally started to see some interest there.

Benz: Right, possibly some good old-fashioned chasing going on there. Kevin, I would also like to talk about municipal-bond funds. You call them the comeback kids of the fund world in 2011, they were quite beaten-down, seeing a lot of redemptions in the first quarter, but they really turned things around, right?

McDevitt: They did. As you said, we saw the most dramatic turnaround, I think, of any asset class with municipal-bond funds. In December of 2010, you had outflows of about a little more than $13 billion out of all municipal-bond funds. But by the end of the year, in December 2011, you had positive flows of about $4.8 billion into those funds. Really, December of 2010 was the low point, that's of course when you had Meredith Whitney in 60 Minutes talking about how she predicted a wave of defaults coming in 2011. Well as we know that, there were some defaults, but there wasn't this mass wave of defaults, which she was predicting, at least in 2011. In fact, municipal-bond funds, as was the case with Treasuries, had quite strong returns, and I think as investors got more comfortable throughout the year, you saw those outflows turn into inflows by December.

Benz: One thing you noted in your report, Kevin, was that we continue to see this strong trend toward investors embracing passively managed products, dumping actively managed products. I think what's been going on at American Funds is probably a good example of how some of the active funds have been seeing inflows. Which categories have investors been buying passively managed products in?

McDevitt: It's really across the board, but there are two areas that stick out at least to me: in the international-stock master class and then also taxable bonds. You've seen very strong flows into passively managed funds in both of those areas. DFA's emerging-markets equity funds have been doing very well, seeing strong inflows throughout the year. Although again that did taper off a bit near the end of the year. Vanguard's Total Stock International Index fund had very strong flows as did Vanguard's Total Bond funds.

So really again taxable-bond and international-stock funds saw very strong inflows. And to an extent, you saw any inflows in U.S. stock funds, those tended to be, again, passively managed vehicles. In aggregate, there is very little positive flow, well there are certainly outflows on the U.S. stock side, but we did see some positive inflows into passively managed funds, too.

Benz: So combined with some of the trends that we've been seeing in exchange-traded funds this indicates that investors in general are really voting with their feet in a lot of ways and saying we'd rather up for these cheap passive products than cast our lot with active fund managers.

McDevitt: Right. That gets back to a dichotomy that we've talked about before, too, which has been really curious to me. You're right, I think in aggregate you are seeing a reluctance to take on manager risk, that investors, it seems, do not want to have as much manager risk in their portfolios. But then earlier in the year, you did see some cases where investors did seem more willing to embrace manager risk, and you saw that with a popularity of some of the nontraditional bond funds, some of the unconstrained bond funds. And you also saw that with world-allocation funds, too, where you saw again investors giving money to managers to who had even broader mandates than the typical actively managed stock manager might have.

So that was a bit of an anomaly there, I thought. But you're right; the overriding theme was seeing very strong flows into passively managed funds at the expense of actively managed offerings.

Benz: It's interesting that active funds you mentioned, Kevin, the unconstrained funds and world-allocation funds, those are the funds where the managers really can go anywhere. So maybe investors are saying, if I am going with an active fund I want to give my manager the most latitude I possibly can.

McDevitt: Right, exactly. It is funny though, too, even there you did tend to see, kind of along the lines of this risk-off, risk aversion we saw from the investors in the second half of the year, those unconstrained, broader-mandate funds saw much stronger flows in the first half of the year. But then a lot of didn't have their best performance in 2011, so you saw flows kind of tend to taper off the second half of the year. And again that applies to a lot of the world-allocation funds and more of the broad-based unconstrained bond funds, too.

Benz: That segues neatly into my next question, Kevin. I'd like to talk a little bit about fund family winners and losers. You mentioned Vanguard once. Are there any other firms that you have identified as being big beneficiaries in terms of new assets recently.

McDevitt: One of the ones that sticks out and we have mentioned this before is DoubleLine with DoubleLine Total Return. It had very strong flows, and that's one of the newer fund families out there,  just based, I think, in part on Jeffrey Gundlach and also the great performance of DoubleLine Total Return. That fund took in tremendous inflows, and I believe for the year the family took in a little more than $10 billion. So it was really a strong year for DoubleLine. That was one of the new entrants.

Of other fund families which had strong returns, you mentioned Vanguard, and also DFA and JPMorgan had strong returns. BlackRock had strong inflows, as well. So a lot of the funds with bond-heavy lineups had such returns, and even with alternatives strategies, too, when it comes to JPMorgan, several of their funds were quite popular in that regard.

Benz: At the other end of the spectrum we've talked about American Funds. Things just don't seem to be getting better there, in fact they are worsening in some respects. The firm has continued to see outflows. Are there any other firms that you would point to as really kind of limping along here in terms of gathering assets?

McDevitt: Sure. It intends to be the more equity-oriented firms. Although that's not necessarily American Funds, that tends to be a theme with some of the other fund families. And you mentioned American; it far and away had their worst year of any other major fund families. Fidelity came in second but was a distant second. Then some of the other equity-oriented shops tended to struggle last year, as well.

It'll be interesting to see if that does change in 2012. To be honest I don't think it will, I don't think the trend will change. And the reason why say that is you saw outflows out of U.S. stock funds in 2009 and 2010, two years in which you had a pretty strong equity rally. And despite that fact, there still were outflows. So it's hard to see how this trend is going to change, at least in terms of U.S. stock funds anytime soon.

Benz: Kevin, I'd like to touch a little bit on PIMCO. Bill Gross had a rare off year in 2011. How did that affect the firm's overall flows last year.

McDevitt: The overall flows were still positive. You have seen some outflows out of PIMCO Total Return, and that has received a lot of press. But I think that can be blown out of proportion very easily. The outflows are just miniscule relative to the fund's overall asset base; they are not really a big proportion of the fund's overall asset base.

So it's nothing like what you've seen out of some of the bigger funds like, again, how I mentioned Growth Fund of America. It's not even close to being on par with that. As I said, though, it has had an impact, and you have seen some outflows out of Total Return. And it's been other funds to some extent within the PIMCO lineup which have been receiving more interest, certainly on the emerging-markets fixed-income side.

Benz: Last question for you, Kevin, you and I have talked about how Fairholme Fund had a terrible year last year. You thought that flows out of Fairholme were stabilizing. Would you still say that's the case.

McDevitt: Well, in the second half of the year, you still saw a continued run of outflows out of the fund. So it really hasn't turned around yet. As you mentioned, perhaps it's possible that worst is over at this point. But you haven't really seen a turnaround yet or at least the fund totally stabilize. I think, again, that will depend to large extent on returns, but also I think at this point the fund at least lost most of those shareholders who put new money in, who were new to the fund perhaps in 2010 or early 2011. I can't imagine there are that many of those shareholders left. A lot of new money has, I think, gone out the door at this point.

Benz: Possibly due to tax-loss selling in the year's waning days.

McDevitt: Right.

Benz: Well, Kevin, thank you so much, it's always interesting to see investor behavior in action through these fund flows. We very much appreciate you shedding light on the latest numbers.

McDevitt: Great thank you, Christine.

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