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By Gregory Warrens

Rising equity markets tend to cover up all manner of sins. Concerns about weak organic growth, poor investment fund performance, or rising expense ratios can get cast aside as assets under management rise and higher-fee-generating equity funds contribute to top-line results. That said, rising equity markets can undermine an asset manager's competitive position when its fund performance has been weak for an extended period and market gains are not being fully reflected in the performance of its funds, as Janus Capital Group (JNS) has experienced this year, with outflows from its fundamental equity funds accelerating. Meanwhile, the prospect of rising interest rates as the Fed tapers its asset-repurchase program has put additional pressure on firms that have seen greater amounts of growth from fixed income over the past five years, like Franklin Resources (BEN) and AllianceBernstein (AB). Not surprisingly, these three firms are currently trading at the lowest price/earnings multiples of the asset managers we cover, with Franklin Resources at the lowest price/fair value estimate overall. Still, we think Franklin Resources holds the best position, with its wide economic moat built on the scale of its operations, the strength of its brands, and the diversity of its assets under management.

Market Pullback Sours Improving Picture for Actively Managed U.S. Equity Funds

While July was a welcome respite for active managers of U.S. equities, as the market climbed more than 5% and monthly flows turned positive again, the euphoria was short-lived, with the S&P 500 TR Index declining 2% since the start of August and actively managed U.S. equity funds going back into net redemption mode. We expect the flow picture to be a bit more subdued for active U.S. equity managers in the back half of 2013, owing to the trend that has been in place over the past 20 years of investor flows during the first half of any given year outstripping those recorded in the back half of the same year. While this is more troubling for the equity-heavy asset managers we cover--namely, Janus, Waddell & Reed (WDR), and GAMCO Investors (GBL), which remain overly reliant on market gains to lift their AUM levels--it will have an impact on the actively managed U.S equity operations of all of our asset managers.

Janus seems to be the poster child for equity outflows right now, as a confluence of poor investment performance, fund manager changes, and investor fatigue with the firm's lack of a turnaround in its investment offering drove monthly outflows to $2.2 billion in July, according to data provided by Morningstar Direct. This represented the worst monthly outflows for Janus since May 2010, when a similar amount of capital flowed out of the company's funds.

Passive Funds Still Garner Most Interest From U.S. Equity Investors

Even after backing out the impact of State Street's (STT) SPDR S&P 500 fund, which tends to be used by traders as a hedge for their own market exposure, flows into exchange-traded funds dedicated to U.S. equities were more than 7 times greater than the $1.6 billion that flowed into actively managed U.S. equity funds in July. Adjusted net inflows of $11.4 billion were on par with what we saw from the category in January (when an adjusted $10.8 billion flowed into ETFs dedicated to U.S. stocks), with year-to-date flows on an adjusted basis at $54.9 billion at the end of July, which is record-setting territory for U.S. stock ETFs. Even if no more money flows into the category for the rest of the year, 2013 will go down as the strongest year of inflows for ETFs dedicated to U.S. equities (both on a regular and an adjusted basis) since the products were first introduced more than a decade ago.

Flows for index funds dedicated to U.S. equities recovered to May levels in July, with the category pulling in $35.2 billion since the start of the year. This is on par with the largest annual flows for the category during the past 10 years, which was $35.3 billion in 2008 (2007 was second-largest at $32.8 billion). Flows through the first seven months of 2013 are at their highest level since 1999, when investors poured $39.6 billion into U.S. equity index funds during the same time frame. While it would be a stretch to believe that flows for the full year will match the record-setting levels of 1999 (when $53.9 billion flowed into U.S equity index funds), 2013 is likely to end up a much closer second to that total than 2008 when all is said and done.

All this affects our coverage universe in varied ways, since relatively few of the publicly traded asset managers offer passively managed products. BlackRock's (BLK) iShares division, the largest domestic provider of ETFs, has done fairly well this year with its U.S. equity offerings, with investor inflows averaging around $2.9 billion per month (and July coming in slightly above average at $3.1 billion). Sector equity ETF flows have been slightly more muted, though, averaging around $600 million per month since the start of the year. And after starting out the year strong (with $8.5 billion in inflows during January), iShares' international equity offerings have been a bit more volatile, with monthly flows averaging less than $200 million since the start of the year. As far as BlackRock's institutional equity index funds are concerned, the firm picked up $16.9 billion in investor inflows during the first half of the year, and looked to have a fair amount in the pipeline in early July, which should contribute to flows in the third and fourth quarters.

Even so, BlackRock continues to be overshadowed by Vanguard, which has been gaining market share not only at the expense of iShares but State Street's SPDR unit as well. At the end of July, Vanguard held sway over 19% of the domestic ETF market, up from 18% at the end of 2012 (while iShares market share dropped from 41% to 39% and State Street saw a minor drop in its share to 24%). That said, total flows into Vanguard's U.S. equity ETFs have been similar to the flows seen at iShares this year, with the firm picking up $2.8 billion per month in investor capital since the start of 2013. Sector equity ETF flows were also comparable with those at BlackRock, averaging around $700 million per month since the start of the year. While flows into Vanguard's international equity ETF offerings were slightly better than what iShares has seen, averaging around $500 million per month, they've been just as volatile.

Sector Equity Fund Flows Continue to Be More Volatile

At $48.8 billion overall through the first seven months of 2013, sector equity funds are on pace to have their best annual flows since 2005 (when $72.7 billion flowed into active and passive sector equity funds overall). While flows look to have fallen off in August, and the category itself has historically seen weaker flows in the back half of the year, we believe full-year flows will end up somewhere between where they are now and the levels seen in 2005.

Stronger Emerging-Markets Inflows Lift International Equity Fund Flows After collapsing in June, flows into international equity funds have returned to the run rate we were seeing in March, April, and May. Much of this is due to improved flows in emerging-market funds, which went negative in June (with $3.9 billion flowing out of actively managed funds, index funds, and ETFs dedicated to international equities -- the largest monthly outflow since February 2011, when $6.3 billion flowed out of the category). If investor inflows remain on the trajectory we've seen so far since the end of the second quarter, then the third quarter would end up well above the average quarterly run rate of $20.9 billion in inflows that has been reported for the segment over the past 10 years (and $12.1 billion over the past five years).

It also looks as if this trend is finally benefiting Franklin Resources, which has not seen inflows on par with the rest of the industry, despite having a well-known brand in Templeton -- a leader in global and emerging-markets investing, with a bent toward value-driven strategies -- as weaker-than-average investment performance following the financial crisis has kept its global/international equity fund offering from gaining much traction. Management believes that sales of Templeton Global Bond and Templeton Global Total Return, which are viewed by some as more akin to equity funds than fixed-income, have usurped sales that might have gone into its global/international equity offerings the last few years. That said, flows for those two funds remain rather subdued, as better-than-average performance in the first few months of the year swung the other way in the aftermath of Fed Chairman Ben Bernanke's comments in May and June that the government would start tapering its asset-purchasing program as early as the end of this year. The focus now has to be more clearly on the performance of Franklin Resources' international equity funds relative to those offered by its peers.

Interest in allocation funds picks up again. After pulling back from allocation funds in June, investors jumped back into them in July, putting $5.9 billion into the category during the month. While flows look a bit weaker in August, we expect the category to close out 2013 in solid shape, as interest in allocation funds tends to pick up more during volatile markets. With flows through the first seven months of the year at $32.8 billion -- the strongest flows for that period since 2007 (when $30.0 billion flowed into the category)--2013 should end up as one of the top annual periods for flows into allocation funds.

Taxable Bond Fund Flows Have Recovered, but Well Off Previous Pace

At $51.1 billion in total outflows, June represented the single worst monthly outflows for taxable bond funds since October 2008 (when $30.0 billion flowed out of the category overall). While there has been renewed interest on the part of investors in July and August, flows are still well off the $22.2 billion monthly run rate that had been in place from January 2009 to May 2013. With investors concerned about the impact that the removal of quantitative easing will have on the bond market, we don't expect to see a significant recovery in flows in the near to medium term. Instead, we expect a continued rotation within the category away from longer-duration and constrained core fixed-income products into more unconstrained strategies.

Much as we saw in June, investors pulled the most capital out of intermediate-term bond funds in July, pulling $15.5 billion out of the category. While this was a meaningful improvement from June (when $26.9 billion was pulled out of these particular bond funds), it still marked the third-largest monthly outflows from intermediate-term bond funds in the past 20 years (with October 2008 being second largest at $15.8 billion). The exodus from longer-duration and constrained core fixed-income products is being offset by inflows into less traditional bond categories like bank loan (with $8.8 billion in total inflows during July), nontraditional ($7.0 billion), and high-yield ($6.9 billion) bond funds.

Detroit Bankruptcy Only Adds to Municipal Bond Fund Woes

After seeing a fairly decent recovery in monthly flows following the Meredith Whitney-induced panic that hit sales and redemptions for municipal bond funds in the fourth quarter of 2010 and first quarter of 2011, when $19.5 billion and $19.9 billion, respectively, flowed out of these funds in reaction to the analyst's prediction that "between fifty and a hundred counties, cities, and towns in the U.S. would have significant municipal bond defaults starting in 2011, totaling hundreds of billions of dollars in losses," the category has struggled to generate positive flows since the end of February 2013. Aside from concerns about the impact that the removal of quantitative easing will have on the bond market in the near to medium term, municipal bond fund flows were hindered more recently by the Detroit bankruptcy filing, which is having a ripple effect on the ability of surrounding Michigan counties to access the debt markets. Total outflows of $16.8 billion from municipal bond funds during June were followed by $10.6 billion in outflows during July, which were the single-largest and fourth-largest monthly outflows, respectively, from the category in the past 20 years (December 2010 at $13.6 billion and January 2011 at $12.8 billion were the second- and third-largest monthly outflows for municipal bond funds).

Alternatives Flourish as Gold Fund Redemptions Affect Flows for Commodities Funds

Net redemptions from gold funds continued in July, bringing the total outflows from precious metals funds to $21.7 billion since the start of the year. This has had a detrimental impact on flows for the entire commodities segment -- which includes funds dedicated to agricultural products, basic materials, precious metals, and energy -- with total outflows from the category reaching $18.4 billion during the first seven months of 2013. The only real winner in the category this year has been commodities broad basket funds, which have seen $4.7 billion in total inflows since the start of 2013. Meanwhile, the alternatives category -- comprising funds dedicated to currencies, futures, and myriad trading strategies -- remains on pace to have its best year ever from a flow perspective, with the $30.6 billion that has flowed in during the first seven months of 2013 more than 60% higher than the highest previous record high (of $18.8 billion in 2012) and more than $5 billion higher than the largest annual inflow we've seen during the past 20 years ($27.8 billion in 2009). The five largest drivers of inflows so far this year have been long/short equity ($10.0 billion), multi-alternative ($5.1 billion), trading-inverse equity ($4.1 billion), bear market ($3.7 billion), and market-neutral ($3.1 billion) funds.

Source: Equity Market Gains Not Lifting All Asset Manager Boats