Morningstar DirectSM Asset Flows Commentary: United States

Morningstar Research
21 March 2018
Data through Feb. 28, 2018
U.S. Mutual Funds and Exchange-
Traded Products
Alina Lamy
Senior Analyst
Quantitative Research
+1 312-384-3924
alina.lamy@morningstar.com
Investors Flee U.S. Equity for International Equity in Aftermath of Market Plunge
February was a roller-coaster month for the U.S. stock market, with all major indexes
plummeting, then floating back up, then dropping again to end the month in negative territory.
This volatility was reflected in the flows, with investors running away from U.S. equity—not
only from active funds but from passive ones as well. Redemptions of $8.4 billion from passive
U.S. equity marked the first monthly outflow for the category since April 2015.
Despite international markets being down last month just like the U.S. market, the
international-equity category group didn’t lose its stride in February. Instead, it dethroned
taxable bond, which had enjoyed the largest flows for quite a while, and took the lead with a
$22.8 billion inflow overall. The majority of this inflow went to passive funds.

Inflation and interest-rate concerns caused taxable-bond flows to diminish last month to only
$5.2 billion. It was the smallest inflow for taxable bond since November 2016. Overall, this
February seems to have been a record of lows, with investors shaken by the wild swings in the
market and keeping their distance. January’s flows across all category groups totaled $128.1
billion. In contrast, February’s total amounted to a negative $7.7 billion.

Active Passive
Estimated Net Flows* Feb Assets Feb Assets
1 Year 1 Year
$Mil 2018 $Bil 2018 $Bil
U.S. Equity (17,691) (220,967) 4,290 (8,376) 198,055 3,703
Sector Equity (2,652) (18,636) 413 (3,289) 33,255 484
International Equity 6,920 54,176 2,009 15,909 217,035 1,294
Allocation (2,823) (26,701) 1,280 (145) 3,620 67
Taxable Bond 3,972 179,697 2,614 1,233 194,031 1,100
Municipal Bond (1,351) 28,977 666 93 5,325 29
Alternative (62) 5,493 173 (433) 5,166 52
Commodities 743 2,962 31 260 1,217 68
All Long Term (12,943) 4,999 11,476 5,253 657,704 6,797
Money Market 42,812 148,321 2,832

*Includes liquidated and merged funds.

     
  
              
  
Morningstar Quantitative Research | 21 March 2018 Page 2 of 10

Total (Active and Passive)

Estimated Net Flows Feb Assets

1 Year
$Mil 2018 $Bil
U.S. Equity (26,067) (22,912) 7,993
Sector Equity (5,941) 14,619 897
International Equity 22,830 271,211 3,303
Allocation (2,968) (23,081) 1,347
Taxable Bond 5,205 373,728 3,714
Municipal Bond (1,258) 34,302 695
Alternative (495) 10,659 225
Commodities 1,003 4,178 99
All Long Term (7,691) 662,703 18,273
Money Market 42,812 148,321 2,832

     
  
              
  

Return (%)
2018 YTD, as of Feb. 28
Morningstar U.S. Market Index 1.5
Morningstar Developed Markets ex-U.S. Index ï0.1
Morningstar Emerging Markets Index 2.8

($ Billion)
              ! " # $ % " & ' ( ) # * ) ( + , ( - " . / # 0 / ( 1 2

30

20

10

-10

-20

-30
Jan 15 Jul 15 Jan 16 Jul 16 Jan 17 Jul 17 Jan 18
3 4 5 6 7 8 9 : 4 6 ; < ; = > ? @ 6 A < 6 8 7 ? B > > 8 ? C D 4 E > F
Morningstar Quantitative Research | 21 March 2018 Page 3 of 10

($ Billion)
       G H - " & ) - % " ! ( - % / I   ! " # $ % " & ' ( ) # * ) ( + , ( - " . / # 0 / ( 1 2

50

40

30

20

10

-10
Jan 15 Jul 15 Jan 16 Jul 16 Jan 17 Jul 17 Jan 18
3 4 5 6 7 8 9 : 4 6 ; < ; = > ? @ 6 A < 6 8 7 ? B > > 8 ? C D 4 E > F

Even without knowing about the February market shock, a reader could have guessed
something serious had happened just by looking at the flows. The February bar in Exhibit 3
paints a picture that is drastically different from the rest of the graph.

($ Billion)
       J $ % " & ' ( ) # * ) ( + 0 / ( 1 2 K ) ! - ' " . & L % 2 " M N , ( - " . 2

140
U.S. Equity Sector Equity International Equity
120 Allocation Taxable Bond Municipal Bond
Alternative Commodities
100
80
60
40
20
0
-20
-40
-60
Mar Apr May June July Aug Sep Oct Nov Dec Jan Feb
2017 2018
3 4 5 6 7 8 9 : 4 6 ; < ; = > ? @ 6 A < 6 8 7 ? B > > 8 ? C D 4 E > F
Morningstar Quantitative Research | 21 March 2018 Page 4 of 10

Top- and Bottom-Flowing Morningstar Categories

Active Passive
Estimated Net Flows* Feb Assets Feb Assets
1 Year 1 Year
$Mil 2018 $Bil 2018 $Bil
Leading
Foreign Large Blend 2,258 19,265 449 12,063 126,113 769
Intermediate-Term Bond 4,717 81,250 895 3,439 83,378 519
Ultrashort Bond 2,157 30,644 139 2,880 11,208 24
Diversified Emerging Mkts 2,201 13,796 364 1,989 46,508 234
Long Government 1,366 3,943 11 1,380 10,534 27
Lagging
High-Yield Bond (9,620) (34,092) 250 (2,853) (1,693) 42
Large Blend (3,308) (41,408) 824 (4,603) 144,188 2,443
Large Growth (8,309) (71,379) 1,413 1,874 22,692 274
Large Value (2,435) (58,249) 959 (2,660) 16,442 283
Health (989) (8,938) 109 (1,693) (1,088) 55

*Excludes money market.

     
  
              
  

Large blend, which used to be among the top-flowing Morningstar Categories despite outflows
on the active side, landed on the bottom-flowing list last month. This category is usually the
beneficiary of passive flows because investors who index tend to prefer large-blend (as
opposed to growth- or value-specialized) funds. With overall passive flows into U.S. equity
taking a dive in February, large blend was the hardest hit.

Foreign large blend and diversified emerging markets remained in the top five as investors
continued to focus on international equity. Intermediate-term bond continued to be the most
popular option in the taxable-bond category.

Interestingly, the flows driven by February’s market shock didn’t seem to discriminate as much
between active and passive. All top five categories experienced inflows on both the active and
passive side, and all categories with the largest outflows (except large growth) experienced
the same pattern. It seems investors are much more meticulous about active versus passive
when it comes to depositing their money than withdrawing it. Susceptible categories
experienced redemptions on both sides, and for one month it seems the “outflows from active,
inflows to passive” pattern was, if not broken, at least disrupted.

High-yield bond experienced outflows for the fifth consecutive month. The Tax Cuts and Jobs
Act may have prompted some of the outflows, because it is limiting the tax-deductible amount
of interest expenses. High-yield debt companies will be negatively affected by this new
Morningstar Quantitative Research | 21 March 2018 Page 5 of 10

provision because their interest expenses are now much higher, and not being able to write
them off will adversely affect profitability.

($ Billion)
       O H - " & ) P & Q ! % " & I R & ) P % - Q S ! ' . I T ! & / Q U ( - Q , ( - " . / # 0 / ( 1 2

25
Intermediate-Term Bond High-Yield Bond
20

15

10

-5

-10

-15
Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb
2017 2018
3 4 5 6 7 8 9 : 4 6 ; < ; = > ? @ 6 A < 6 8 7 ? B > > 8 ? C D 4 E > F

Top 10 U.S. Fund Families by Assets Under Management

Active Passive
Estimated Net Flows Feb Assets Feb Assets
1 Year 1 Year
$Mil 2018 $Bil 2018 $Bil
Vanguard (1,535) 12,614 987 13,140 299,139 3,385
American Funds 2,223 23,726 1,557
Fidelity Investments (5,454) (36,505) 1,121 6,418 62,096 381
BlackRock/iShares 76 (17) 218 8,472 209,470 1,413
SPDR State Street Global Advisors 82 1,703 7 (25,351) 25,605 616
T. Rowe Price (3,050) (9,591) 571 (642) (6,757) 31
Dimensional Fund Advisors 2,904 30,727 408
Franklin Templeton Investments (2,512) (29,758) 375 52 540 1
PIMCO 533 35,898 349 (175) 37 4
J.P. Morgan 482 (2,504) 296 74 2,347 9

     
  
              
  
Morningstar Quantitative Research | 21 March 2018 Page 6 of 10

If one still had any lingering doubt about how bad last month actually was in terms of flows,
one only had to look at Vanguard: almost $33 billion in January, barely $12 billion in February. If
the reigning provider saw such a drop, just imagine what everyone else must have endured.

($ Billion)
       V , ( - " . / # 0 / ( 1 2 H - " ( " . & R ( + M W 0 - Q 0 % P ! / ! & 2

Vanguard American Funds Fidelity BlackRock/iShares

120
State Street T. Rowe Price Franklin Templeton DFA
100 PIMCO JPMorgan

80

60

40

20

(20)

(40)
Feb 17 Mar 17 Apr 17 May 17 Jun 17 Jul 17 Aug 17 Sep 17 Oct 17 Nov 17 Dec 17 Jan 18
3 4 5 6 7 8 9 : 4 6 ; < ; = > ? @ 6 A < 6 8 7 ? B > > 8 ? C D 4 E > F

On the active side, American Funds managed to stay positive with a $2.2 billion inflow (all its
funds are active). The two funds with the largest inflows were American Funds EuroPacific
Growth AEPGX and American Funds American Balanced ABALX.

On the other hand, Fidelity, T. Rowe Price, and Franklin Templeton continued to suffer outflows
from their active funds.

After two months of double-digit billion-dollar flows, State Street experienced an extreme
$25.3 billion outflow driven by its flagship exchange-traded fund, SPDR S&P 500 SPY
(discussed in more detail below).
Morningstar Quantitative Research | 21 March 2018 Page 7 of 10

Top-Flowing Active and Passive Funds

Assets Assets
Estimated Net Flows Feb 2018 1 Year Feb 2018 Feb 2017
$Mil
$Mil $Mil

Active Funds
Fidelity Series Investment Grade Bond 1,709 4,774 28,512 23,531
T. Rowe Price U.S. Treasury Long-Term 1,224 4,239 4,504 400
Oakmark International 1,149 11,832 46,862 27,826
American Funds EuroPacific Growth 1,098 6,622 167,637 127,750
John Hancock Diversified Real Assets 967 967 937 ---
Passive Funds
iShares Core MSCI EAFE ETF 6,882 28,584 51,973 18,682
Vanguard Total Stock Market Index 6,842 50,081 681,860 541,309
Vanguard Total Intl Stock Index 5,036 32,840 338,517 251,607
Vanguard 500 Index 4,867 50,196 410,439 306,379
iShares Core S&P 500 ETF 4,283 39,102 154,537 97,844

     
  
              
  

Oakmark International OAKIX maintained a place on the top-flowing list in February. PIMCO
Income PIMIX, however, was nowhere to be seen. Ironically, the active funds with the largest
inflows were two fixed-income funds from providers with severe active outflows.

American Funds EuroPacific Growth was the preferred choice of investors looking to diversify
overseas. My colleague Gregg Wolper, who covers this fund, writes that it “remains
impressive: It has a very experienced management group, an appealingly low cost, a strong
performance record, and a reliable parent. It retains its Morningstar Analyst Rating of Gold. This
fund will have down periods due if nothing else to its hefty emerging-markets stake, but it
remains a strong choice.”

On the passive side, two iShares ETFs and three Vanguard index funds received the largest
inflows in February. All five of these funds track U.S. or international stock indexes.
Morningstar Quantitative Research | 21 March 2018 Page 8 of 10

Bottom-Flowing Active and Passive Funds

Assets Assets
Estimated Net Flows Feb 2018 1 Year Feb 2018 Feb 2017
$Mil
$Mil $Mil

Active Funds
T. Rowe Price New Income (1,746) (2,548) 30,242 32,406
BlackRock High Yield Bond (1,373) (4,765) 15,096 19,224
PIMCO High Yield (1,273) (3,064) 8,443 11,231
Wells Fargo Ultra Short-Term Muni Inc (1,218) (1,935) 3,470 5,357
Harbor International (1,143) (11,580) 28,210 34,653
Passive Funds
SPDR S&P 500 ETF (19,643) 4,314 275,420 235,228
Vanguard Institutional Index (4,440) (33,522) 227,837 224,915
iShares MSCI EAFE ETF (3,730) 3,908 79,572 63,919
iShares iBoxx $ Invmt Grade Corp Bd ETF (3,237) 2,097 32,768 31,132
SPDR Blmbg Barclays High Yield Bond ETF (2,232) (3,184) 8,964 12,721

     
  
              
  

Bronze-rated T. Rowe Price New Income PRCIX sustained a $1.7 billion outflow, the largest
among active funds. Two active high-yield bond funds, one from BlackRock and one from
PIMCO, also landed on the bottom-flowing list in February.

Harbor International HAINX, a foreign-large-blend fund, continued its 2017 outflow streak
owing to its “opportunistic misfires, middling results, and rising expenses,” in the words of
senior analyst Kevin McDevitt.

Passive funds with large outflows included Vanguard Institutional Index VINIX, two iShares
ETFs, and a SPDR high-yield bond ETF. Their outflows, however, were nowhere near the $19.6
billion that SPDR S&P 500 SPY bled last month.

SPY, State Street’s flagship ETF for the U.S. market, received the largest flows in December
and January. The large December inflow is a recurring trend each year as active managers
rebalance their holdings and use this ETF to temporarily store cash. However, the large January
inflow was surprising because it went against the trend.

SPY has a history of severe outflows at the beginning of the year, because it is used frequently
by active mutual fund investors and hedge funds as a holding when they want to maintain
equity exposure. When fund managers reallocate their portfolios at the end of the year by
selling stocks, they may not know what new stocks they plan to purchase. These managers
Morningstar Quantitative Research | 21 March 2018 Page 9 of 10

then purchase SPY so their funds don't exhibit large tracking error while they figure out their
plans. In January, these managers sell SPY and buy individual stocks for their portfolios.

As Exhibit 6 illustrates, over the past five years (except in 2015), there has been a pattern of
very large inflows in December and large outflows in January for SPDR S&P 500 ETF. This year,
the pattern was delayed by a month. SPY received a significant positive flow in January
because of U.S. stocks’ solid January return. The large outflow occurred in February instead of
in January, as investors shifted allocations from U.S. to international equity.

Flows for SPDR S&P 500 at Year-End ($ Billion)

       X

30

20

10

-10

-20

-30
NovDecJan NovDecJan NovDecJan NovDecJan NovDecJan NovDecJan Feb
2012 2013 2014 2015 2016 2017
3 4 5 6 7 8 9 : 4 6 ; < ; = > ? @ 6 A < 6 8 7 ? B > > 8 ? C D 4 E > F
Morningstar Quantitative Research | 21 March 2018 Page 10 of 10

Note: The figures in this report were compiled on Mar. 12, 2018, and reflect only the funds
that had reported net assets by that date. The figures in both the commentary and the
extended tables are survivorship-bias-free.

This report includes both mutual funds and exchange-traded funds, but not funds of funds
unless specifically stated. It does not include Collective Investment Trusts (CITs) or separate
accounts.

Important methodology note: Morningstar computes flows using the approach that is
standard in the industry: Estimated net flow is the change in assets not explained by the
performance of the fund. Our method assumes that flows occur uniformly over the course of
the month. Adjustments for mergers are performed automatically. When liquidated funds are
included, the final assets of the fund are counted as outflows. Reinvested dividends are not
counted as inflows. We use fund-level reinvestment rates to improve accuracy in this respect.
We make ad hoc adjustments for unusual corporate actions such as reverse share splits, and
we overwrite our estimates with actual flows if managers are willing to provide the data to us.
Please click here for a full explanation of our methodology.

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