John Rogers’ Ariel Investments 2nd Quarter 2014 Commentary   Fundamental risks in the BRIC countries

We will come right out and say it: this has been a strange year for the markets so far. In 2014, through mid-April, the S&P 500 Index took a bumpy trip to nowhere—or technically a +0.02% gain. Since then, however, it has returned +7.54%. According to the Wall Street Journal, the S&P 500 has also had 16 record closes in the second quarter of 2014, and its volatility has dropped to the lowest level since 2007. At this point in a bull market, you might expect record highs and low volatility to drive unencumbered exuberance, but not this time. On the one hand, the Investors Intelligence Advisors Sentiment Charts show 61% are bullish on the market and 16% are bearish, with the rest expecting a correction. On the other hand, market pundits continue to detect fear, skepticism and worse in market movements. One global strategist recently told Bloomberg Businessweek: “Classically, the market climbs a wall of worry. Now we’re having a wall of hatred.”

A look at asset flows suggests what investors are doing, and what it might mean. When we examined 56 Morningstar mutual fund categories and find the biggest inflows in dollar and percentage terms in the first five months of 2014, some fairly clear patterns emerge.

John Rogers: The biggest dollar inflows in our universe

Below are the 15 categories with the biggest dollar inflows in our universe (boldface indicates the style also saw a big percentage jump in assets relative to previous levels).We will come right out and say it: this has been a strange year for the markets so far. In 2014, through mid-April, the S&P 500 Index took a bumpy trip to nowhere—or technically a +0.02% gain. Since then, however, it has returned +7.54%. According to the Wall Street Journal, the S&P 500 has also had 16 record closes in the second quarter of 2014, and its volatility has dropped to the lowest level since 2007. At this point in a bull market, you might expect record highs and low volatility to drive unencumbered exuberance, but not this time. On the one hand, the Investors Intelligence Advisors Sentiment Charts show 61% are bullish on the market and 16% are bearish, with the rest expecting a correction. On the other hand, market pundits continue to detect fear, skepticism and worse in market movements. One global strategist recently told Bloomberg Businessweek: “Classically, the market climbs a wall of worry. Now we’re having a wall of hatred.”

A look at asset flows suggests what investors are doing, and what it might mean. When we examined 56 Morningstar mutual fund categories and find the biggest inflows in dollar and percentage terms in the first five months of 2014, some fairly clear patterns emerge. Below are the 15 categories with the biggest dollar inflows in our universe (boldface indicates the style also saw a big percentage jump in assets relative to previous levels).

John Rogers: Record-low bond yields

In our view, two themes jump off the page. First, in this world of record-low bond yields, investors seem to be steadfastly hunting for assets that have solid yields. Into this bucket we would place Nontraditional Bond, Multisector Bond, High Yield Bond, Energy Limited Partnership, Bank Loan (as an alternative to cash), and World Bond. Second, there is a distinct preference among equities for categories associated with lower volatility and stability. In this group we include Foreign Large Blend, (U.S.) Large Blend, Foreign Large Value, World Stock, and (U.S.) Large Value. While it is true that large caps almost by definition tend to attract larger dollar amounts, some of those fund types also had big inflows relative to their previous asset levels, and we do not see growth funds, which many associate with volatility and a more aggressive strategy, in the heavy inflow categories. We now turn to Morningstar categories with significant outflows.In our view, two themes jump off the page. First, in this world of record-low bond yields, investors seem to be steadfastly hunting for assets that have solid yields. Into this bucket we would place Nontraditional Bond, Multisector Bond, High Yield Bond, Energy Limited Partnership, Bank Loan (as an alternative to cash), and World Bond. Second, there is a distinct preference among equities for categories associated with lower volatility and stability. In this group we include Foreign Large Blend, (U.S.) Large Blend, Foreign Large Value, World Stock, and (U.S.) Large Value. While it is true that large caps almost by definition tend to attract larger dollar amounts, some of those fund types also had big inflows relative to their previous asset levels, and we do not see growth funds, which many associate with volatility and a more aggressive strategy, in the heavy inflow categories.

John Rogers: Categories with significant outflows

We now turn to Morningstar categories with significant outflows.

Unlike the popular categories, almost all the unloved categories saw fairly significant percentages of their assets flow out— suggesting they became far more out of favor this year. The first theme is a distinctly skeptical view of U.S. growth. Not only were Large Growth, Small Growth and Mid-Cap Growth part of this group, but the sector funds dedicated to consumers (both Defensive and Cyclical) and the pro-cyclical Financial group were included as well. Second, investors are avoiding aggressive international investments, including Emerging Markets Bond, Pacific/Asia ex-Japan Stock, China Region, Diversified Pacific/Asia (Equity), and Latin America Stock. Finally, investors dumped some of the most “vanilla” bond categories—both Intermediate Government and Inflation-Protected Bond.

John Rogers: Fundamental risks in the BRIC countries

All told, these themes help explain what we have seen this year. While the data certainly does not indicate panic or even widespread fear, it suggests a conservative, cautious approach to staying invested. Some of this seems very sensible to us, but not all of it. For instance, we think it makes sense to be somewhat restrained in the emerging markets. Over the last decade, some investors have gone overboard estimating probable rewards and underestimating fundamental risks in the BRIC countries (Brazil,Unlike the popular categories, almost all the unloved categories saw fairly significant percentages of their assets flow out— suggesting they became far more out of favor this year. The first theme is a distinctly skeptical view of U.S. growth. Not only were Large Growth, Small Growth and Mid-Cap Growth part of this group, but the sector funds dedicated to consumers (both Defensive and Cyclical) and the pro-cyclical Financial group were included as well. Second, investors are avoiding aggressive international investments, including Emerging Markets Bond, Pacific/Asia ex-Japan Stock, China Region, Diversified Pacific/Asia (Equity), and Latin America Stock. Finally, investors dumped some of the most “vanilla” bond categories—both Intermediate Government and Inflation-Protected Bond. All told, these themes help explain what we have seen this year. While the data certainly does not indicate panic or even widespread fear, it suggests a conservative, cautious approach to staying invested. Some of this seems very sensible to us, but not all of it. For instance, we think it makes sense to be somewhat restrained in the emerging markets. Over the last decade, some investors have gone overboard estimating probable rewards and underestimating fundamental risks in the BRIC countries (Brazil, Russia, India, and China) and elsewhere.

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