Fund Investors Lose Appetite for Risk-Taking

Here with me to dig into the details is Morningstar's Kevin McDevitt. He is an editorial director on our fund research team.

Kevin, thanks for calling in today.

Kevin McDevitt: Thank you, Jason.

Stipp: Kevin before this conversation, you said to me that there are two words that in some ways sum up some of the broader trends that you've seen in the fund flow data for November. What is it at the top level that you say characterizes these fund flows?

McDevitt: It was really a "risk off" month in November, and you saw that primarily in the outflows out of both U.S. stock funds and international stock funds. And then on the flipside of that, there has been strong inflows into taxable bond funds and municipal bond funds as well. And on top of that, you saw a real resurgence into money market funds too.

Stipp: On the fixed-income side, did you also see similar trends, where investors were shying away from risk?

McDevitt: Yes, you did. It's interesting. In the early part of the year, you saw very strong inflows into high-yield bond funds, bank-loan funds, and really more of the credit oriented side of the categories of those asset classes.

And now you're seeing the opposite. You're seeing more of the core, more conservative fund groups, such as intermediate-term bond funds, muni national intermediate term bond funds, short-term bond funds, and even government bond funds, which had been seeing outflows, but after their great returns in recent months, you've seen a real resurgence into those more "conservative categories," where there is greater perceived safety.

But also, at least for this year, you haven't had to make a trade-off in terms of return. Those have also been the areas, again, more the core taxable bond and core muni bond categories, that have seen the best returns, too.

Stipp: So, I know there has been some tension between the quest for yield--and we still see that fixed-income yields are pretty low--and the quest for safety. So, given recent market volatility, it seems like that quest for safety is winning out, at least right now?

McDevitt: Absolutely, and you have really seen that in particular with money market funds. Money market funds had about $46 billion in inflows last month, in November. I believe that was about the fourth best month they've had in about three years. So, even though yields are essentially nothing in money market funds, you're still seeing that desire for a safe haven.

Stipp: Kevin, you also had some interesting data about how this year is shaping up compared with 2008, which is, of course, when we saw the intense market shocks and the financial meltdown. How are we shaping up this year compared to that really rough year in the market?

McDevitt: What's so striking is, of course 2008 was really the low point in terms of the financial crisis, the worst of the financial crisis in the fourth quarter of 2008, and naturally you saw a lot of money flowing out of U.S. stock funds. I believe the final tally was about $98 billion, and we're not quite there yet, but through November, we've had about $74.5 billion in outflows out of U.S. stock funds. I think that's so striking because you've had certainly a rebound in the overall market since the lows in March of 2009, but this year hasn't been a great year, but it hasn't been a terrible year, either; the market has been down a bit, but nothing compared to 2008. But yet, we've still seen such tremendous outflows. So, I think that more than anything is a great barometer of investor sentiment and shows how much less appetite there is for risk-taking these days.

Stipp: I know this is somewhat of a harder question, maybe it requires some speculation--but do you know where some of that money might be going? So, you said recently money markets have seen an uptick. Where are investors putting this money if they're taking it out of these domestic equity funds?

McDevitt: We have looked at that in a couple of different ways, and ... certainly bond funds have been the primary beneficiary in terms of the mutual fund universe. Interestingly, you haven't really seen that on the money market side, although you did have this surge last month. Year-to-date, you've had big outflows out of money market funds, about $135 billion has left money market funds.

And we looked at this a couple of months ago, and we hypothesized that, to some extent, that money must be going or is likely going in part to bank accounts, checking accounts. I think investors potentially are looking at the fact that you no longer have that backstop for money market funds that you had in 2008. The government, part of the Dodd-Frank reform, is that you're not going to have that backstop for money market funds again.

So, I think it's possible you might see investors saying, "Well, look, I'm not getting yield no matter where I go, so I might as well be in a saving account where I at least have some protection in terms of a government backstop."

So, I'd say a couple of different areas--again, I think bank deposits are picking up as a result, and also, again, on the mutual fund side, it's mostly going to bond funds.

Stipp: On the international front, what sort of trends are you seeing? We've obviously seen international news affecting the domestic markets here, particularly news out of Europe. How are investors reacting to that?

McDevitt: Well, ... as with U.S. stock funds, you're seeing a steady flow out of the core international stock funds. Out of categories like Foreign Large Blend, you're seeing tremendous outflows out of that category. That is, I think, where a lot of investors go for their core foreign exposure. So, that's not terribly surprising.

The element that is a bit surprising is, you're still seeing fairly strong flows into your emerging-market bond funds and diversified emerging-market stock funds. Now, granted, flows are down from where they were earlier in the year, but even though neither category has performed well this year, you're still seeing money going into those funds.

With emerging-market bond, you saw about $800 million go into that category in November. You saw close to $750 million go to diversified emerging-market stock funds. Again, even though those have been--especially on the equity side, diversified emerging-market stock funds have been among the worst performers year-to-date.

So, it just shows you, though, how strong that narrative of stronger growth and even potentially a safe haven that could be found, potentially, in emerging markets, how strong that narrative is with investors. So, even in the face of poor returns, they're still putting money there.

Stipp: So, we've certainly heard a lot fund managers talk about the fundamentals in emerging markets being stronger, that they have better growth prospects, especially with a middle class emerging in a lot of these countries. We see their sovereign balance sheets are looking better than some of the developed countries.

But when you look at it, Kevin, from an analyst point of view, and you think about the volatility that investors might see in an asset class like emerging markets, do you think that there is going to be attenuated volatility in that asset class, given these stronger fundamentals? Or could investors be in for a few shocks here if we see some kind of global correction?

McDevitt: It’s really hard to see how volatility would come down, especially because there seems to be much more volatility in developed markets. It's hard to imagine a scenario where you'd have continued volatility in developed markets, but see relatively light volatility in emerging markets; that's one thing.

But on top of that is the fact that you do have potential headwinds in emerging markets, too, from a fundamental standpoint. While valuations have come down from where they were, you still have some real threats. For one thing, the developed market export markets for a lot of these [emerging-market] companies are not doing well, certainly with the low growth in the U.S. and in Europe. But then you also have the overhang of China and the fact that growth in China is potentially slowing. You've had rates come down in China, and if China starts to slow, then that also means slowing demand for commodities, which have been a real source of growth for a lot of emerging markets, especially markets like Mexico and Brazil.

So, if you start to see China start to reduce its appetite for commodities, if growth starts to slow, that's a real headwind for emerging markets that's somewhat independent of what's happening in the Europe and the U.S.

Stipp: So some very interesting and potentially troubling dynamics that we're seeing in how investors are putting their money to work overseas.

Kevin, I'd like to talk to you a little bit about individual fund companies, individual funds. Any notable trends that cropped up out of the November data?

McDevitt: Sure. The most striking thing is that there were no real clear winners in November. Again, flows were pretty tepid across the board, but you did see a few sources, a few pockets of strength. One of the clear ones was with DoubleLine. DoubleLine has continued to see strong flows throughout the year, but in November it had about $1.2 billion in inflows.

JPMorgan was there as well, with its Core Bond Fund doing well. The firm overall took in about $1.2 billion. But what's interesting is, even though you had very strong flows into both taxable and municipal bond funds, you didn't see strong flows for either Vanguard or for PIMCO, and both have very strong fixed-income lineups. So that was somewhat curious. On PIMCO's side you actually saw outflows out of the flagship PIMCO Total Return, and also out of their Unconstrained Bond Fund, which had been really popular earlier in the year.

Stipp: I know you mentioned Vanguard there. It makes me think about one trend that we have been following--active versus passive. Have you seen anything about whether investors are continuing to prefer passive investments over actively managed funds?

McDevitt: We are seeing more evidence of that, especially on both the international stock side and the domestic stock side. But really this past month and this past year, you've seen it very strongly internationally. In the Foreign Large Blend category, I mentioned before, you've seen real outflows out of that category for the year-to-date, which is true, but one exception to that has been Vanguard Total International Stock Market Index, which has taken in, I believe, about $12 billion, which is miles ahead of its nearest competitor. I think the next closest fund has taken in a little over $1 billion. So, even though that category overall, and especially actively managed Foreign Large Blend funds have really struggled this year in terms of flows, that Vanguard fund is a clear exception.

Stipp: Kevin, some very interesting data on fund flows. As always it's great to check in with you to get your insights on that data. Thanks for calling in.

McDevitt: Thank you so much, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.