Investors Continue to Put More Stock in Bonds

Well-diversified asset managers are attracting more inflows in the current environment

Greggory Warren, CFA 29 June, 2011 | 5:39PM
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This article was first published on, a U.S.-focused sister website of and contains asset flows data for the U.S. market.

Convinced that we were still in a "risk-aversion" cycle at the beginning of the year--with investors likely to gradually increase their risk appetite during stable and expanding markets, only to pull back dramatically during market declines--I was surprised to see so much capital go into equities during the first few months of 2011, especially given all of the unrest in the Middle East and the slough of natural (and not so natural) disasters that impacted several major economies in the Asia-Pacific region. But during the last couple of months, things seem to have trended back toward the "risk-aversion" theme that we've observed since the market bottomed in March 2009, as concerns over the ongoing debt crisis in Europe, the struggling U.S. housing and employment markets, rising oil and gas prices, and the impending end of the Fed's second round of quantitative easing (dubbed QE2) all have weighed on the willingness to invest in equities. While the S&P 500 Index (SPX)is still up marginally year to date, the benchmark index has lost more than 5% of its value since the start of May, with investors signalling their displeasure by pulling back more dramatically on their commitment to both U.S. and international stock funds.

According to data provided by Morningstar Direct, investors pulled more than $4 billion out of U.S. stock funds during the month of May; based on our own estimates, investors are on pace to pull another $6 billion out this month. This compares rather unfavourably with the more than $26 billion that was diverted into these same funds during January and February of 2011. Inflows into international stock funds are also well off the pace set during the first quarter, with less than $2 billion flowing into these funds in May and what we estimate to be a return to net outflows this month. In the meantime, inflows into taxable bond funds have picked up some steam, looking to close out the first half of 2011 at more than $100 billion. Should this trend persist through the second half, we could see a third-straight year with investor inflows into taxable bond funds in excess of $200 billion. Also of note is the fact that the mass exodus from municipal bond funds that started in November seems to be winding down, with net flows being flat in May and likely to return to positive territory in June.

With most equity markets having recovered to pre-bear-market levels, and the long-term prospects for equity returns looking somewhat better than those for fixed income (based on the fact that bond yields are at historically low levels and bond prices likely will fall once interest rates go up again), one would think that average quarterly inflows would have returned to something closer to what they looked like in the 10 years prior to 2008.

Instead, investors continue to favour taxable bond funds in a big way, with average quarterly inflows exceeding $60 billion since the market bottomed in March 2009. While investor enthusiasm for taxable bond funds waned a bit during fourth-quarter 2010 and first-quarter 2011, inflows during the second quarter of this year look to be more in line with the trend we've seen during the last two years.

It's also interesting to note that even when including the impact of exchange-traded funds (ETFs) on the quarterly inflow data, taxable bond funds continue to trump inflows into U.S. and international stock funds by a fairly wide margin.

Investors Continue to Favour Risk Aversion and Capital Preservation
The root of this trend, in our view, is the fact that annualised U.S. stock market returns during the last 10 years (as represented by the total return of the S&P 500 Index) have been slightly more than 3%, with investors subjected to a far greater degree of volatility than one would expect for such meagre returns. It is this uptick in volatility that also has made investors far more risk averse than they were earlier in the decade, when they quickly jumped back into equities after the bursting of the dot-com bubble, the calamity of 9/11, and the market-timing scandal in 2004-05. What's also different this time around is that both the housing and employment markets are in complete disarray, which we feel is having an even more profound impact on how retail investors look at money and investing.

Putting safety over returns, investors have pumped more than $500 billion into fixed-income funds during the last two years, with both 2009 and 2010 representing record years of inflows for bond funds and 2011 on pace to generate another strong year. While some of this can be attributed to the aging of the baby boomers--with the first wave of post-World War II babies starting to hit 65 years of age in 2011 and likely moving some assets from equities over to fixed income--the shift in investor sentiment cannot be laid solely at the feet of retirees. Nor can it be wholly attributed to retail investors, as institutional investors also have poured a lot of capital into fixed-income products during the last two years. While some of this also can be linked back to the aging of the baby boomers, especially in relation to legacy pension plans, we believe most of it is tied to concerns over capital preservation.

So What Will It Take To Get Investors Interested in U.S. Stock Funds Again?
While we believe that we will see continued improvement in the U.S. economy over the long run, which should lead to job growth (and a reduction in the unemployment rate), as well as a recovery in the housing market, we think that things will be bumpy along the way. As such, we believe that risk aversion will continue to rule the day, with investors showing a willingness to gradually increase their risk appetite during stable and expanding markets, and pulling back dramatically during market declines--a scenario that we saw play out rather clearly during 2010 on two separate occasions. First, when investors pulled money out of U.S. and international stock funds in May of last year in response to the European credit crisis, as well as the "flash crash" trading glitch that knocked the Dow Jones Industrial Average down more than 600 points in a matter of minutes. And again in November 2010, when investors started pulling money out of municipal bond funds at a rapid pace over fears that state and local governments, which have had their tax revenues savaged by the downturn in both the economy and the housing market, would no longer be backstopped by the federal government.

While we had expected to see a similar rush for the exits this year--following the collapse of the Tunisian and Egyptian governments (and the outbreak of civil war in Libya), as well as the spate of natural disasters in Japan, Australia, and New Zealand--net outflows from U.S. stock funds did not turn strongly negative until May. We have, however, seen a marked uptick in inflows into taxable fixed income (and even a modest recovery in flows into municipal bond funds) since the end of February, adding to the large influx of capital that already has gone into fixed income during the last two years. We believe this trend, which has helped drive bond yields to historic lows, ultimately will reverse itself when the Fed starts raising interest rates. When this does happen, it not only will wake investors up to the risks that exist in bonds, but finally could push them back into equities, where the long-term risk/reward trade-off might look more appealing.

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Greggory Warren, CFA  Greggory Warren, CFA, is a senior stock analyst with Morningstar.

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