By Greggory Warren
Convinced that we were still in a "risk-aversion" cycle at the beginning of the year -- with investors likely to gradually increase their risk appetite during stable and expanding markets, only to pull back dramatically during market declines -- I was surprised to see so much capital go into equities during the first few months of 2011, especially given all of the unrest in the Middle East and the slough of natural (and not so natural) disasters that impacted several major economies in the Asia-Pacific region. But during the last couple of months, things seem to have trended back toward the "risk-aversion" theme that we've observed since the market bottomed in March 2009, as concerns over the ongoing debt crisis in Europe, the struggling U.S. housing and employment markets, rising oil and gas prices, and the impending end of the Fed's second round of quantitative easing (dubbed QE2) all have weighed on the willingness to invest in equities. While the S&P 500 Index (SPX) is still up marginally year to date, the benchmark index has lost more than 5% of its value since the start of May, with investors signaling their displeasure by pulling back more dramatically on their commitment to both U.S. and international stock funds.
According to data provided by Morningstar Direct, investors pulled more than $4 billion out of U.S. stock funds during the month of May; based on our own estimates, investors are on pace to pull another $6 billion out this month. This compares rather unfavorably with the more than $26 billion that was diverted into these same funds during January and February of 2011. Inflows into international stock funds are also well off the pace set during the first quarter, with less than $2 billion flowing into these funds in May and what we estimate to be a return to net outflows this month. In the meantime, inflows into taxable bond funds have picked up some steam, looking to close out the first half of 2011 at more than $100 billion. Should this trend persist through the second half, we could see a third-straight year with investor inflows into taxable bond funds in excess of $200 billion. Also of note is the fact that the mass exodus from municipal bond funds that started in November seems to be winding down, with net flows being flat in May and likely to return to positive territory in June.
With most equity markets having recovered to pre-bear-market levels, and the long-term prospects for equity returns looking somewhat better than those for fixed income (based on the fact that bond yields are at historically low levels and bond prices likely will fall once interest rates go up again), one would think that average quarterly inflows would have returned to something closer to what they looked like in the 10 years prior to 2008.
Instead, investors continue to favor taxable bond funds in a big way, with average quarterly inflows exceeding $60 billion since the market bottomed in March 2009. While investor enthusiasm for taxable bond funds waned a bit during fourth-quarter 2010 and first-quarter 2011, inflows during the second quarter of this year look to be more in line with the trend we've seen during the last two years.
It's also interesting to note that even when including the impact of exchange-traded funds (ETFs) on the quarterly inflow data, taxable bond funds continue to trump inflows into U.S. and international stock funds by a fairly wide margin.
Investors Continue to Favor Risk Aversion and Capital Preservation
The root of this trend, in our view, is the fact that annualized U.S. stock market returns during the last 10 years (as represented by the total return of the S&P 500 Index) have been slightly more than 3%, with investors subjected to a far greater degree of volatility than one would expect for such meager returns. It is this uptick in volatility that also has made investors far more risk averse than they were earlier in the decade, when they quickly jumped back into equities after the bursting of the dot-com bubble, the calamity of 9/11, and the market-timing scandal in 2004-05. What's also different this time around is that both the housing and employment markets are in complete disarray, which we feel is having an even more profound impact on how retail investors look at money and investing.
Putting safety over returns, investors have pumped more than $500 billion into fixed-income funds during the last two years, with both 2009 and 2010 representing record years of inflows for bond funds and 2011 on pace to generate another strong year. While some of this can be attributed to the aging of the baby boomers -- with the first wave of post-World War II babies starting to hit 65 years of age in 2011 and likely moving some assets from equities over to fixed income -- the shift in investor sentiment cannot be laid solely at the feet of retirees. Nor can it be wholly attributed to retail investors, as institutional investors also have poured a lot of capital into fixed-income products during the last two years. While some of this also can be linked back to the aging of the baby boomers, especially in relation to legacy pension plans, we believe most of it is tied to concerns over capital preservation.
So What Will It Take To Get Investors Interested in U.S. Stock Funds Again?
While we believe that we will see continued improvement in the U.S. economy over the long run, which should lead to job growth (and a reduction in the unemployment rate), as well as a recovery in the housing market, we think that things will be bumpy along the way. As such, we believe that risk aversion will continue to rule the day, with investors showing a willingness to gradually increase their risk appetite during stable and expanding markets, and pulling back dramatically during market declines -- a scenario that we saw play out rather clearly during 2010 on two separate occasions. First, when investors pulled money out of U.S. and international stock funds in May of last year in response to the European credit crisis, as well as the "flash crash" trading glitch that knocked the Dow Jones Industrial Average down more than 600 points in a matter of minutes. And again in November 2010, when investors started pulling money out of municipal bond funds at a rapid pace over fears that state and local governments, which have had their tax revenues savaged by the downturn in both the economy and the housing market, would no longer be backstopped by the federal government.
While we had expected to see a similar rush for the exits this year -- following the collapse of the Tunisian and Egyptian governments (and the outbreak of civil war in Libya), as well as the spate of natural disasters in Japan, Australia, and New Zealand -- net outflows from U.S. stock funds did not turn strongly negative until May. We have, however, seen a marked uptick in inflows into taxable fixed income (and even a modest recovery in flows into municipal bond funds) since the end of February, adding to the large influx of capital that already has gone into fixed income during the last two years. We believe this trend, which has helped drive bond yields to historic lows, ultimately will reverse itself when the Fed starts raising interest rates. When this does happen, it not only will wake investors up to the risks that exist in bonds, but finally could push them back into equities, where the long-term risk/reward trade-off might look more appealing.
Diversified Asset Managers Still Hold the Strongest Hand
With the uncertainty that still exists in the markets (and the economy), and investors' overall penchant for risk aversion, we think the more diversified asset managers in our coverage universe remain the best positioned to capitalize on the current environment. That said, we continue to believe it pays to be selective when looking at firms in this category, such as BlackRock (BLK), Franklin Resources (BEN), Invesco (IVZ), Legg Mason (LM), and AllianceBernstein (AB). Of these five names, we continue to have concerns about Legg Mason, which has had more trouble than most maintaining its assets under management (AUM). The firm's problems started well in advance of the bear market, as poor relative investment performance at its Western Asset Management division, which accounts for two thirds of Legg Mason's managed assets and is the main source of its fixed-income AUM, started a flood of outflows that has yet to reverse itself. In an environment where record levels of investor capital have flowed into bonds, Legg Mason has been unable to provide fixed-income products that would allow it to successfully attract and retain investors. And lacking the scale in equities it has in fixed income, the firm is also unlikely to garner enough inflows from its stock offerings to cover losses from its bond funds once investor sentiment does start to shift from fixed income to equities.
AllianceBernstein is another one of our well-diversified asset managers that has struggled with outflows during much of the last two years. Much like Legg Mason, the firm has seen a significant level of outflows from its institutional client base, with the main difference being that AllianceBernstein's equity offerings have taken the hit. While relative fund performance has been improving, it is still poor during the last three- and five-year time frames, which are important benchmarks for most institutional investors. Since the equity markets bottomed in March 2009, AllianceBernstein has seen close to $140 billion in outflows from its equity operations, with most of the redemptions driven by institutional investors. Lacking the level of equity performance it needs to not only attract new investors but hold on to those it already has, AllianceBernstein has had to rely on market appreciation (which can be volatile) and an expansion of its fixed-income business (which generates lower fees than its equity operations) to maintain its AUM.
Our Top Three Picks in the Asset Management Industry
With the market struggling to eke out a gain this year, and bond funds continuing to generate a much higher degree of interest than stock funds from investors, we continue to believe that the more broadly diversified asset managers with solid equity and fixed-income franchises will generate more consistent inflows. Firms that can provide access to ETFs or have a fair amount of international business in their portfolios get an added boost. As always, we believe that companies with some relative stickiness in their asset base (whether through a diversified product offering or a niche that allows them to hold on to assets for longer periods of time) will outperform in the long run, especially if they're capable of generating new business. While less diversified niche managers like T. Rowe Price (TROW) and Eaton Vance (EV) normally would fit this bill, we think the following three managers are far more attractive, not only from a product diversity perspective but on a price/fair value (P/FV) and price/earnings (P/E) basis:
Trading at 29% discount to our $32 fair value estimate, and 12.7 times this year's (and 10.8 times next year's) consensus earnings per share estimate, Invesco is currently one of the cheapest asset managers on our list. With a product portfolio that is fairly diverse by asset class, distribution channel, and geography, and a stronger ability than most of our asset managers to generate organic growth in the near term, we feel that the market has mispriced Invesco's shares. One year into its integration of Van Kampen, management has been working hard to deepen its relationship with clients and consultants. Once that is complete, we expect the firm to be a far more formidable competitor domestically, with the size and scale necessary to secure placement on a wide array of platforms. With Invesco strong in the defined contribution and defined benefit channels and Van Kampen strong in the broker/dealer channel, the company also can work toward cross-selling the best products from each of its fund families as well as expand its PowerShares ETF operations. The firm also should benefit from the geographic reach of its operations, which includes a meaningful presence in several of the fastest-growing and most attractive markets in the world. Given the cross-selling opportunities created by the Van Kampen deal, and the fact that Invesco's legacy operations are now firing on all cylinders, we believe that the firm is well-positioned to generate solid results regardless of the market conditions.
Trading at 24% discount to our $248 fair value estimate, and 14.6 times this year's (and 12.7 times next year's) consensus EPS estimate, BlackRock is not as much of a bargain as Invesco, but is still attractively priced. We continue to believe that BlackRock has the widest moat in the asset management industry. Besides being the largest asset manager in the world, with more than $3.5 trillion in AUM, the firm's diverse product portfolio and ability to offer both active and passive investment strategies gives it a huge leg up on competitors. BlackRock's ownership of iShares, the leading provider of ETFs, leaves it with not only a strong growth vehicle but a tool for building out its presence in the retail channel. With a significant portion of AUM sourced from institutional clients, BlackRock also has one of the stickiest asset bases in the industry. The firm is also more geographically diverse, with clients in more than 100 countries and close to 40% of its AUM coming from investors outside of the U.S. and Canada. We expect cross-selling opportunities within BlackRock's traditional base of institutional clients, which have shown a growing interest in passive investments, and efforts to expand the firm's reach into the retail channel, to drive solid near-term growth. With much more stable cash flows than many of its peers, we feel BlackRock should be able to continuously reinvest in its business, making it all that much harder for some of its smaller competitors to keep pace.
Trading at 19% discount to our $156 fair value estimate, and 14.2 times this year's (and 12.9 times next year's) consensus EPS estimate, Franklin also is not as much of a bargain as Invesco. With more than $735 billion in managed assets, though, the firm is one of the larger global asset managers. It also has been the poster child for how well diversification can work in an asset manager's portfolio. While Franklin traditionally has been more equity-heavy, the dramatic shift in investor risk appetite during the last several years has left it with a more balanced portfolio. Franklin also has been one of the better internal growth stories in our coverage universe, generating a significant amount of inflows through its fixed-income division during the last two years (which has led to an average quarterly rate of organic growth of around 3%). While we expect the firm to see outflows from its bond fund offerings once interest rates rise and risk appetite increases, we think that Franklin is perfectly placed on the equity side of the business (especially with its global/international funds) to capitalize on any shift in investor sentiment. With solid investment performance across both its fixed-income and equity divisions, we continue to believe that Franklin is one of our better-positioned asset managers.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.