It's not been a good recovery for actively managed mutual funds. Investors have been steadily pulling money out, while sending waves of cash into passively managed index funds and exchange-traded funds.
Domestic large cap stocks, the core of every investor's portfolio and the jewel in the fund industry's crown, were particularly hard hit. From June 2010 through this June, investors yanked nearly $250.7 billion from actively managed US large cap mutual funds, while sending $97.5 billion to their passively managed, or indexed, counterparts, according to Morningstar. In the same period, they funneled $32.8 billion to ETFs that invested in US large cap stocks. Between 2007 and 2010 investors pulled $250.7 billion from actively managed US large cap funds. But in that same period, they sent $105.6 billion to US large cap ETFs, and $97.5 billion to US large cap indexed funds.
"Active large caps were hurting before the financial crisis started, and there's no direct linkage between money out of US large active and into ETFs," Syl Flood, the analyst in charge ETF fund flows at Morningstar, says. "But the money's going somewhere and that's where I suspect it's going." Flood notes that some of the cash getting siphoned out of stock mutual funds is going, most likely, into taxable bond mutual funds, which have seen a sharp increase in investor interest since the start of the bear market, specifically high yield bond funds. It's not an unreasonable assumption. Witness the world's biggest mutual fund: PIMCO's Total Return Bond Fund, with just under $243 billion. Compare that to the start of 2007, when that PIMCO fund was the third largest at $99.7 billion.
"Investors have called into question the value of active management over the last several years," admits Larry Wasserman, head of equities due diligence at UBS. He heads the committee at UBS that selects mutual funds for a list from which advisors can choose. Active managers can provide added value, particularly during bear years, like 2008, Wasserman says. But the merit of losing less money than their benchmark index is often lost on disappointed investors. Nonetheless, Wasserman says, if investors stick with them, there are a few stars out there. "There are managers with disciplined investment processes, who have consistency of delivering excess return over performance benchmarks; not quarter over quarter, but over a good market cycle," he says. "Investors suffer a myopic view of the world. Things come down to quarterly numbers, with investors watching CNBC. That can create a lot of hype in the marketplace. Investors need to realign their thinking to what's the purpose of an equity investment? It's an inflation hedge, looking at three, five and 10-year cycles."
The Quant Teams Problem
Industry consultant Geoff Bobroff suggests that the heavy bleeding suffered by actively managed large cap stock funds are due, at least in part, to committees like those headed by Wasserman. He says that the majority of sales today are done by advisors through internal lists of funds approved by a quantitative team. "That means out of 50 or 100 or 150 funds in a family, maybe three or five are on that approved list, and that's all. And 90% of the business is being directed by that medium. It's bringing about what I'd call a commoditization of the asset management business."
Bobroff says that quant teams measure a fund against a bogey — whether that's a benchmark, or a peer group, or some other yardstick determined by the committee — quarterly. "You can miss it for a quarter or two, and after that, if you fail, you get replaced." As a result, he says, the average holding period for funds has gone down dramatically, because the approved list is changing so frequently. That mentality of not sticking around to see if a manager can improve performance would also account for the rapid-fire movement of cash in and out of funds.
For their part, Paul Weisenfeld, head of the mutual funds and ETF business at Morgan Stanley Smith Barney, and the head of fund research at UBS say the cash leakage from actively managed large cap equity funds is not coming from their shops. Each reports healthy cash flows into all types of actively managed mutual funds, including large cap equities. Peter Thatch, head of global funds at Merrill Lynch Global Investment Solutions, says he has seen less demand over the last three to four years for US stock funds, specifically large cap. But he says it was not necessarily due to the ascendancy of ETFs. He points to investor demand for more flexible and tactical global asset allocation funds.
Indeed, global, or world asset allocation funds have been the belle of the mutual funds ball recently. Although investors do not appear to have much use for active managers when it comes to large cap stocks, they're happy to trust their judgment in asset allocation.
Thatch says that these global, or world, asset allocation funds had performed well in the downturn of the last few years, with smaller losses than a lot of style-box oriented funds. "That being the background, if I'm going to get market returns in large cap, why not use the ETF to do that and I'll pay somebody who will navigate me through the uncertainty in the world today," Thatch says. Frequently, managers of these popular global asset allocation funds themselves use ETFs to get quick exposure to the US large cap market, Thatch says. He cites BlackRock Global Allocation Fund and First Eagle Global Fund as examples of popular funds using this tactic.
Weisenfeld of MSSB, also calls the global asset allocation funds an "obvious winner" with investors of late. He says that it has been the number one allocated strategy in gross sales for the last eight months, adding that was "pretty close to the top" in net cash flows for the last three to four months. "We're seeing slightly less style box investing and financial advisors relying a little bit on the asset managers to be more nimble and do their allocation," he says. "I don't want to suggest we're getting totally away from style box, but when it comes to allocating to individual funds, we're seeing financial advisors rely on fund portfolio managers to allocate."
Rise of Absolute Return Funds
The mutual fund industry is still working to spot trends in investors' appetites and capitalize on them. World allocation funds are one success story. Another is the rise of absolute return funds. That has been one of the biggest trends over the last 12 to 18 months, according to Ryan Leggio, a fund analyst at Morningstar. These funds capitalize on extreme investor nervousness after 2008, exemplified by the 500-point plunge in the Dow, the biggest one-day drop since the financial crisis in 2008, just as OWS was going to press. Absolute return funds also speak to worries about inflation. They are designed to post positive returns over a certain period of time in any kind of market environment. "Because the fund managers can be very flexible in their asset allocations, they're designed to give investors a little bit more peace of mind," Leggio says.
Putnam Investments was one of the leaders of the trend, rolling out its series of Absolute Return Funds, numbered 100, 300, 500 and 700, in December 2008, with Leggio calling the move "very opportune timing." Each fund aims to give investors a return above three-month Treasuries. Absolute 100's goal is to return 1% per year over three-month Treasuries; the goal of 300 is 3% a year over three-month Treasuries, and so on. Leggio adds that as always, advisors and investors should understand what the fund was designed to do. "The goal is not promising 5%-plus Treasuries every single year over three to five years," he says. "It's promising it on average over the three-to-five year period. So maybe one year it does a little less, another year it does really well."
As always, advisors should look under the hood. The load shares of Putnam Absolute Return 100, (PARTX) cost 1.01% for a fund that Leggio says is "essentially investing in short-term bonds." Leggio notes that the average short-term bond fund costs 0.74%, making the Putnam offering 25% more expensive. Many of the absolute return funds sport fees above their peer group, he adds.
It's difficult to say precisely how much more expensive absolute return funds are than ordinary funds, because it's not clear how many of them there are. There are 52 funds with the words "real return" or "absolute return" in the name; that group holds assets of more than $55 billion. But Leggio says the universe is bigger than that, as other funds are pursuing the same strategy without the magic words in the name. Beyond name games, it's tricky to quantify the funds because many use different techniques, landing them in different Morningstar categories. Some perch in the long-short equity group, others in world allocation. Leggio says that most absolute return funds are charging management fees of between 1% to 2%.
There are a growing number of funds jockeying for investor cash in the absolute return arena. Each month seems to bring a new one, Leggio says. MFS Investment Management rolled out one in March; Palmer Square Capital Management and Janus came to market with their offerings in May. Three of the biggest are the Permanent Portfolio, with $13.4 billion in assets, PIMCO's All Asset, with $23 billion, and PIMCO's All Asset All Authority, with $12 billion.
Advisors should note that most of the absolute return funds do not carry an insurance component, and so cannot guarantee investors a specific return. "A lot of these investors think 'I'm in a 500 fund, I'll never lose money,'" Leggio says. "But these funds can certainly lose a lot of money in a bear market. It's still an open question how many of these investors understand what they're getting into because none of these funds can guarantee any type of return," he adds.
There are a few such funds which do offer insurance, aiming specifically at protecting investors from severe losses. These are grouped in a separate category with funds using "tail risk" strategies. But not all of these funds aim to offer protection with insurance; some use derivatives.
Thatch of Merrill Lynch is also a bit wary of the funds, saying, "It makes a lot of sense from an advisor perspective, but since products are new, are they going to deliver on their goals through an entire market cycle? That remains to be seen." He adds that regardless of their appeal to anxious investors, advisors at Merrill have not sold a lot of them. "It's challenging us on, 'How do you use them in portfolio construction?' Are they out of the equity bucket or the fixed income bucket? How does it fit within a client's needs? There needs to be a lot more education on these products within clients and advisors."
Investors' hunger for security is driving another hot trend: funds using alternative strategies. "They think hedge strategies will do better if we have another 2008 or some other unknown shock in interest rates or who knows what else," Morningstar's Leggio says. He notes that interest in this category had languished in 2004 to 2005, in part of 2006 and only seeing a spike in interest in 2008, with the onset of a bear market.
Along with the desire for safety is the desire for yield, and that drives another trend in mutual funds, the popularity of bank loan funds (see chart). "Investors like them because they offer higher yields than any other short-term fixed income funds. They're competing with money market funds and short-term bond funds and CDs," Morningstar's Flood says. The funds have taken in a net $42.4 billion, with just one month of outflows since the start of 2009.
Wasserman from UBS notes two more reasons for the funds' popularity. One, bank loans are generally less than 10 years to maturity, which works for investors who have seemed leery of holding bonds with too long a maturity. "Investors are not sure it pays to be on the longer end of the curve," he says, adding that the funds came with a variable rate of interest, so if rates rise, the funds would be likely suffer less than funds holding investment grade debt. "It's more a place to park for safety," he says.
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