Stock and Bond Funds Grow with the Flows

At last, mutual fund investors are moving money toward domestic equities. The investment community has long wondered when this would happen, when the great stock rally would induce the retail investor to return to the equity market. Yet throughout all the gains, right through last December, investors continued to pull their money out of domestic U.S. equity funds. Even as January seems to have brought that looked-for change, things are unfolding differently than the common wisdom had expected. It had anticipated that when investors made their move toward stocks, they would redistribute funds away from bonds. But, in fact, all major classes of funds have seen inflows so far this year. It would seem that rather than a redistribution the flows reflect a general growth in wealth.

Still, the renewed interest in equities is significant. It should persist, and, contrary to popular belief, it likely will accelerate as the Federal Reserve raises interest rates later this year. The inflows eventually should help the stock market realize its remaining value. In the fullness of time, such flows, as they gain momentum, will create an overvaluation and set the stage for the next cyclical equity correction. That circumstance is, however, a long way off, given both the tentative nature of current inflows and still-attractive equity valuations.

The Unfolding Picture in Equities
Outflows in the face of a strong equity rally had created a strange picture. History would have indicated a redistribution in favor of equities long before now, not the least because fixed-income yields, especially on better-quality credits, were less than compelling. In all likelihood, the change failed to occur because the huge losses of 2008–09 had unnerved equity investors, especially since most also could remember the great losses of 2000–02. Many financial advisors were also reluctant to push equity investing for fear that another downdraft would jeopardize their practice. So, even as recently as 2014, net outflows brought down assets in domestic equity funds by 1.0%, despite a 14.04% total market return,¹ at least as measured by the S&P 500^® Index.²

Only foreign equities attracted interest. These consistently saw inflows through much of this time, even though foreign stocks showed more volatility and less net gain than domestic U.S. equity funds. Investors evidently had fewer bad memories of overseas stocks than of domestic stocks, surely less because the foreign alternative had protected them than because fewer mutual-fund buyers had experienced those losses and so felt less bruised. Hybrid funds also attracted net inflows during this time, likely because scarred equity investors felt that they offered some protection against the sudden downdrafts in stocks that they feared.

But beginning with this new year, these strange patterns began to change, at least in part. In the weeks through late February (the most recent period for which data are available), net flows into U.S. equity mutual funds turned from negative to a positive average of $1.6 billion a week—not a shabby gain, even on a base of $6.2 trillion outstanding in such funds at the end of 2014. Flows into foreign stocks held up, growing on average at $1.0 billion a week, which actually is a faster relative growth on this category’s year-end 2014 base of $2.1 trillion. Hybrid funds also continued their gains, growing slightly more than $950 million a week, also a greater proportion of their base of $1.3 trillion.

Redistribution
But as indicated, none of this reflects the long-awaited redistribution away from bonds. On the contrary, flows into both taxable and municipal bond funds have held up well so far this year. Bond funds overall have enjoyed inflows averaging $4.0 billion a week during this recent time, far higher than equities and faster relative to their outstandings at $3.4 trillion. Taxable bond funds have enjoyed inflows averaging $3.0 billion a week, while tax-exempt funds have seen inflows of $1.0 billion a week—this last a particularly strong 9.2% annualized rate of gain on the $566 billion outstanding amount in such funds as 2014 closed. Fed statistics confirm that these patterns reflect less a redistribution than a general increase in wealth, showing in the four quarters through the end of September 2014( the most recent period for which data are available) household net worth up some $5.1 trillion, or 6.7%.

This pattern of broad-based net additions to holdings should persist until later this year, when the Fed, as promised, begins to raise interest rates. At such a time, bond yields will rise, modestly, no doubt, but enough to create capital losses in long bond funds, which have returned their coupon or better over much of the last seven-plus years. Money will want to turn elsewhere. Shorter-term funds are a clear choice. Some monies will likely go to lesser credits and municipals, which, because of relatively favorable valuation spreads, will suffer less than higher-quality issues, such as Treasuries, agencies, and the best corporate credits. Given the Fed’s determination to raise interest rates, albeit gradually, this general relative return pattern should persist, sustaining these newer fund flows.

Equities should benefit from the redistributions, too. Though under other circumstances rising rates would raise questions about stock investing, equities at present show sufficient enough value to withstand anything but the most powerful of rate hikes, something that is hardly likely. Dozens of metrics can illustrate the extent of this value. One is adequate here to make the point. Presently, stocks on average yield about 2.0% on dividends alone, well above cash yields, which are negligible. Historically, cash yields 200 basis points higher than stocks, not the nearly 200 basis points lower than stocks do today. The gap speaks not only to the value remaining in stocks but also to how much of an adjustment is necessary before rate increases can erase that attractive relative value.

As indicated, flows into equities eventually should help stocks realize their value, especially as those flows gain momentum. That is plain. It also is plain that such a day is a long way off, likely ensuring that equity inflows will build and persist for the foreseeable future.

¹All data herein from the Investment Company Institute (ICI).
²The S&P 500^® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries. An index is unmanaged, does not reflect the deduction of fees or expenses, and is not available for direct investment.

A basis point is 1/100 of a percentage point.

Note about Risk: Different types of investments carry different types of risk. Stocks are subject to greater risk and market volatility. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise, and as interest rates rise, the prices of debt securities tend to fall. Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent to international investing, including those related to currency fluctuations and foreign, political, and economic events. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that the market will perform in a similar manner under similar conditions in the future.