(By
Greggory Warren, CFA) Optimism
and positive performance in the third quarter gave way once again to
the realities of markets and economies that continue to be fraught with
risk and uncertainty. As if concerns about slowing growth in both
developed and developing economies, the European debt crisis, and the
upcoming U.S. elections and pending fiscal cliff weren't enough, the
wide swath of destruction caused by Hurricane Sandy, which shut down
trading on Wall Street for two full days, left investors once again
pursuing the relative safety of bonds. The decline in the S&P 500 TR
Index last month had less of an impact on flows for actively managed
U.S. stock funds than we anticipated, but was still the fourth-largest
monthly outflow recorded this year. With investors continuing to favor
fixed income over just about every other asset class, flows into
actively managed taxable bond funds have surpassed the level of inflows
seen in all of 2010 and could reach the record level seen during 2009.
We continue to believe that the more broadly diversified asset managers,
especially those that offer a mix of active and passive strategies,
strong equity and fixed-income franchises, and exposure to both domestic
and international markets, are best positioned in this environment.
No Relief From Net Redemptions From Actively Managed U.S. Stock Funds
The decline in the S&P 500 TR Index last month had less of an impact
on flows for actively managed U.S. stock funds than we anticipated, but
with more than $32 billion pulled out of the broad asset class during
August and September (when the market was actually going up), we think
investors were looking to avoid the next downturn in the markets, taking
advantage of the runup in stock prices overall to take some cash off
the table before the end of the third quarter. The nearly $12 billion in
outflows that hit actively managed U.S. stock funds during October were
the fourth-largest monthly outflows recorded this year, with the
category (at more than $97 billion in net redemptions through the first
10 months of 2012) on pace to surpass the level of outflows seen not
only in 2011, but during 2008 as well. As we noted last month, we think
this has far more to do with the performance of active managers than it
does the direction of the markets. According to Morningstar's index
data, domestic stock funds as a whole (which includes large-, mid- and
small-cap funds dedicated to growth, blend, and value strategies) were
underperforming the benchmark S&P 500 TR Index by around 150 basis
points through the first three quarter of 2012, with no single category
outperforming the S&P 500 TR Index at the end of the third quarter.
This was also the case last year, with domestic stock funds overall
trailing the benchmark index by around 250 basis points through the
first nine months of 2011, so it is no real surprise to see this year's
outflows from actively managed U.S. stock funds tracking the results
that were reported last year. While we should acknowledge the impact
that American Funds is having on the overall tally, especially in a
category like large-cap growth, where American Funds Growth Fund of
America has reported more than $28 billion in outflows year to date,
compared with the nearly $30 billion in net redemptions reported for the
large-cap growth segment overall, we have seen the outflows from
American Funds diminish over time, leading us to believe that investor
dissatisfaction is now on the rise in other parts of the actively
managed U.S. stock fund category; this is not too surprising, given the
underperformance that has been seen overall for the category over the
past two years.
U.S. Stock Index Fund Flows Turn Positive, While ETFs Go Into Net Redemption Mode
While flows for actively managed U.S. stock funds were once again
negative during October, index funds had a decent month, with flows into
Vanguard Total Stock Market Index accounting for more than half of the
$4 billion that flowed into the category last month. While its
counterpart in the ETF market--Vanguard Total Stock Market ETF--saw
positive flows as well, the category itself went into net redemption
mode, as outflows from State Street's SPDR S&P 500 contributed more
than two thirds of the $11 billion in outflows that were seen during
October. As this fund tends to be heavily influenced by movements in the
Volatility Index produced by Chicago Board Options Exchange, seeing
bigger movements in month-to-month flow data in periods of greater
market volatility (much like we saw during the weeks leading up to the
U.S. elections this month), we're not too surprised to see the category
dip into net redemption mode. The mood did little to damp Vanguard's
monthly flows, which have averaged around $1.2 billion per month this
year (and $1.1 billion over the past two years) allowing the firm to
continue to capture share at the expense of its peers. It should be
noted, though, that BlackRock has made some strides with its efforts to
combat some of its share losses, much of which has been driven by lower
fees structures on core U.S. equity products offered by Vanguard and
others in the retail channel. BlackRock's decision to cut fees on six of
its larger, more liquid core asset class ETFs, which is where iShares
has been hit the hardest, and offer four new long-term ETFs with lower
fees seems to be working, with this core series of iShares ETFs
garnering $2 billion in inflows since their launch last month. With
BlackRock also integrating its own U.S. retail salesforce with iShares
sales team, while at the same time initiating a global brand push and
marketing effort behind its ETF offerings, the firm should be able to
maintain its market-leading position in the category.
Sector Stock Fund Flows Cool as Investors Walk Away From Real Estate and Utilities
Looking at the sector stock category, which includes such heavy hitters
as Vanguard REIT Index Fund, Vanguard Health Care, and Vanguard Energy,
as well as their counterparts in the ETF market, investors pulled back
dramatically during October. While real estate funds continued to see
positive flows during the month, the run rate was well off what was seen
in the category over much of the past year. Utility funds also remained
in net redemption mode, no doubt over concerns that the Bush-era tax
cuts would be allowed to expire at the end of this year if President
Obama was elected to a second term. For those not familiar with the
specifics, current law taxes both dividends and long-term capital gains
at a maximum federal rate of 15%, which has been the case since 2003.
Assuming nothing changes, dividends will be taxed as ordinary income (up
to 39.6%) starting in 2013, with long-term capital gains taxed at half
the ordinary rate (up to 19.8%). A new health-care-related tax on
investment income for high earners will tack on another 3.8 percentage
points to both rates next year, which helps explain why some investors
have soured on both the real estate and utilities sectors, which have
traditionally offered some of the best yields among different stock
sectors.
International Stock Fund Flows Improve, With Actively Managed Funds Seeing Biggest Improvement
Excluding the impact of American Funds, flows for actively managed
international stocks funds moved back into positive territory last
month, after spending most of the third quarter in net redemption mode.
We continue to be dumbfounded a bit by last quarter's action, given that
the international stock category overall was performing better than all
three benchmark indexes--the MSCI World Ex US NR, MSCI EAFE NR, and
MSCI EM PR--through the first nine months of 2012. But much as we saw
with U.S. stock funds, it looks like investors were looking to avoid the
next downturn in the markets before it actually happened. American
Funds Capital World Growth & Income continues to have the biggest
impact on flows for actively managed international stock funds, with the
fund losing another $1.4 billion to net redemptions during the month of
October. While the picture might be a bit muddled on the actively
managed side of the business, flows for international stock index funds
and ETFs continued to be strong. Diversified emerging market funds
continue to be the biggest drawer of investor attention--seeing close to
$25 billion in investor inflows so far this year--with the Vanguard
Emerging Markets Stock Index fund, and its corresponding ETF, continuing
to generate the lion's share of the inflows (at close to $12 billion
year to date). That said, the announcement from Vanguard early last
month that it was switching 22 of its biggest index funds away from
benchmarks provided by MSCI as part of its effort to lower costs is
having an adverse affect on flows for funds like Vanguard MSCI Emerging
Markets ETF because of the replacement benchmark's significant
difference from the MSCI index. This is turning out to be a short-term
boon for BlackRock's iShares MSCI Emerging Markets Index and the
recently launched iShares Core MSCI Emerging Markets Index Fund, which
saw more than $1 billion in positive flows last month and continue to
attract the attention of institutional investors that have their
international equity exposures benchmarked against MSCI indexes and
would need the approval of their boards to adjust their investment
mandates.
Investor Flows Into Taxable Bond Funds Edge Even Closer to Record Territory
With investors continuing to favor fixed income over just about every
other asset class, flows into actively managed taxable bond funds (at
$199 billion through the first 10 months of 2012) have now surpassed the
level of inflows seen in all of 2010 ($192 billion) and could reach the
record level of inflows seen during 2009 ($255 billion) if flows in
November and December exceed the $27 billion seen during October. Even
if flows stay closer to the $20 billion monthly run rate seen so far
this year, the category would close out the year with $239 billion in
total inflows. Adding in the flows for passively managed products brings
the total flows for taxable fixed income this year to $271 billion,
well beyond the $247 billion that flowed into the broad asset class
overall in 2010 and likely to surpass the $330 billion that flowed into
the category overall in 2009. Inflows into intermediate-term bond funds
continue to dominate the flows going into both actively managed and
passively managed taxable bond funds, with high-yield bond funds and
short-term bonds funds continuing to battle for that more distant
second-place spot. It is also interesting to see flows into municipal
bond funds remaining relatively robust, considering how much of a pariah
they were during the first three quarters of last year. This could,
however, be the result of some investors rotating into tax-free
investments in anticipation of increased taxes after the elections this
year.