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Until the last few years, mutual fund flows followed performance. Recently, however, money has flowed disproportionately into bond funds and out of US equity funds despite a strong rally in the equity markets. Changing demographics explain this shift, which has important implications for advisors and the mutual fund industry.
What follows is the first of a series in which I will explore macro trends that are having a significant and often-misunderstood impact on the mutual fund industry today. In part two, I will explore the long-term trend in interest rates and monetary policy and how this impacts the distribution and advice side of our profession. In part three, I will provide a broad historical perspective on current issues surrounding the appropriate standard of fiduciary care for advisors and broker dealer reps and I will tie this back to the trends explored.
For at least three decades, the mutual fund industry has benefited from several wonderful tailwinds, some of which are in the process of shifting. Once these tailwinds become headwinds, it will be quite easy to recognize poor products and distribution strategies. Until then, fund executives need to apply the same forward-looking analysis and critical thinking currently used to pick individual securities in their approach to product, marketing and distribution. The beneficiaries of the emerging trends that I outline will be those firms that have a history of successful marketing to registered investment advisors. Some mutual fund companies have avoided this channel altogether. If you have ever asked the question “How do you market to RIAs?” pay special attention to what follows.
Examining the data on fund flows
The last six years for most equity-based mutual fund companies have been challenging. Fortunately for them, revenues are a function of assets under management and not net new flows; if funds were generating revenues purely on new asset flows, many would be facing illiquidity and insolvency today. But, most sales plans, business modeling, new product launches and planning considerations are based on what worked when the industry was growing rapidly and not what is appropriate for the current environment.
The surge into bond funds, especially in the last two years, has padded the bottom lines of many bond shops. But most industry participants, as they have done often in the past, are holding their breath waiting for the tide to turn – waiting for the familiar “rush” back into higher-margin equity funds.
The Investment Company Institute (ICI) in its yearly Fact Book has documented how both bond and equity mutual fund inflows are typically closely correlated with their respective market performances. In the past, investors have consistently lightened up on what was not working while stocking up on what was. (This approach rarely works, of course, but that’s another story.) In the 2012 edition, however, the ICI noted that domestic equity funds have now seen six consecutive years of outflows despite recent robust returns from equities. 2012 now marks year seven in this trend.
Both secular and demographic trends have been offered as possible explanations. The secular trend, as one might expect, is caution among investors after two major equity sell-offs in one decade. More important, though, has been the aging demographic profile of US investors and their need to reduce equity exposure in their portfolios.
Exhibit 1, below, illustrates net domestic and global equity flows. Note that the global flows have maintained some of their historical relationship to market performance – particularly on the upside.
The discontinuity is stark. But what’s the link to demographics? Why are aging investors seemingly abandoning their historical behavior? The answer is in how investors’ equity preferences change as they age.
Exhibit 2 shows Vanguard’s analysis of what trends drive investors’ equity allocation decisions in accounts where target date funds (which provide the selection for the investor) are not used. It lends support for the suggestion that age generally plays a more important role in the amount of risk taken in a portfolio than does the incidence of volatility in the market place. Prevailing market conditions are noted as an influence with respect to plan participants, but predominantly during times when they are enrolling for the first time in defined contribution (DC) plans and the market is selling off. In such cases, those aged 55 and older show the most sensitivity to equity allocation when enrolling during market sell-offs. However this tendency across participants at large (including those who are already enrolled) for the period 2005–2010 was found to have been “muted”.
Exhibit 3 provides clearer insights into the average allocation to equities, which decline with the age of the investor over all time periods measured., If anything, at least the younger participants have been more inclined to increase as opposed to decrease their equity exposure at survey periods which correspond to volatile markets, as highlighted in the shaded area. An aging demographic profile in the US is playing a more pronounced role in equity mutual fund flows than is the caution elicited from two market selloffs in one decade.