Ariel Investments commentary for January 2015.
In January 2013, we devoted our monthly commentary to asset flows and have since found it a good way to kick off the year. Interestingly, before the 2007-2009 financial crisis, it was a rather dry task to track the amounts investors put into and pulled out of various mutual funds. In the wake of that epic bear market, however, investor behavior shifted dramatically and made the topic more intriguing. The flows from 2012 showed a big preference for bonds over stocks, a huge swing from actively managed equity portfolios to passive ones and a much greater fondness for funds with stellar short-term performance. The 2013 flows looked better, with inflows to taxable bond, international stock and U.S. stock funds (including active U.S. stock funds), and less performance chasing.
Ariel Investments: Capital inflows in traditional asset classes
The 2014 flow data show a return to the behavior that concerned us from 2008 to 2012. All four big, traditional asset classes— U.S. equity, international equity, taxable bond and municipal bond—had inflows in 2014. That said, of the $201 billion flowing into the four groups, $107 billion went to international equity, taxable bond funds attracted $51 billion, $29 billion flowed to municipal bond funds, and U.S. equity received a mere $13 billion. One of the smart, key themes of this century has been a push toward more global portfolios, so many investors have been playing catch up with their international allocations. While the huge inflows to international stock funds therefore make some sense, we are puzzled by muni bonds drawing twice as much money as U.S. stocks.
The split between actively and passively managed funds was also a bit lopsided in certain places. International equity funds saw a very balanced and, to our minds, reasonable mix of active and passive flows: $56 billion went to active funds and $51 billion to passive. Municipal bonds, where inefficiencies likely exist and state tax laws impact preferences, skewed heavily toward active funds: $28 billion flowed into them with less than $1 billion in passive inflows. In taxable bond funds, on the other hand, while $64 billion poured into bond index funds, investors yanked $13 billion away from active managers. The picture was even worse, to our minds, for U.S. equity funds, where outflows of $94 billion from active funds nearly matched inflows of $107 billion to passive vehicles. We understand the case for passive management, but those numbers suggest a mass exodus from active management and huge faith in passive funds.
Ariel Investments : Performance-chasing back with a vengeance
The most daunting news is that performance-chasing is back with a vengeance. The simplest way to track it is via the very popular Morningstar Star Rating.1 As you know, top-performing funds (on a risk-adjusted reward basis) receive five stars while those with the softest performance receive just one star. The groups, however, are not even in size: 10% receive five stars, 22.5% four stars, 35% three stars, 22.5% two stars, and just 10% get one star. This pattern reflects a standard distribution, suggesting a lot of funds to be typical, with a smaller number above and below that group. In the three biggest asset classes, more than 100% of inflows to active funds in 2014 went to five-star funds. Put differently, that means that 10% of the funds older than three years got all the money. For instance, all the actively managed international funds with ratings collectively saw inflows of $31 billion, but $42 billion went to five-star funds (one-, two-, and three-star funds had outflows). Active taxable bond funds with one-, two-, three-, and fourstar ratings all had outflows with a grand total of $124 billion; five-star active bond funds attracted $86 billion. Active U.S. equity funds were quite similar: $144 billion in outflows from funds in the one- to four-star group while only five-star funds experienced inflows, totaling $35 billion.
Taken altogether the mutual fund flow picture looks extreme. It suggests that, first and foremost, some investors may be underinvesting in U.S. stocks. It also seems a large group of investors have abandoned active managers and are going passive no matter the asset class. Finally, as a group, investors are only writing checks to actively managed portfolios that have outperformed a lot recently. We think the assessment of a mutual fund necessarily involves more than simply knowing about the last 10 years of returns. A better picture would include a longer track record, manager history, costs, investment strategy, and so forth. Ultimately, we fear those with a thirst for hot performance may instead receive a large, ice-cold serving of reversion to the mean.