By Greggory Warren, CFA
With the domestic equity markets up 9% during the first two months of 2012 and most international stock markets posting equally solid returns, we expect most of the asset managers we cover to see increases in their assets under management. However, investor capital continues to be directed primarily at fixed-income assets, with intermediate-term bond funds picking up the largest share of investor inflows. With passively managed U.S. and international stock funds capturing almost all of the money flowing into equity and fixed income continuing to be the asset class of choice for a risk-averse market, we believe the more broadly diversified asset managers, especially those with solid equity and fixed-income franchises, exchange-traded fund platforms, and the ability to offer exposure to international markets, will hold the strongest hand.
Investors Shun Actively Managed U.S. Stock Funds
Despite stronger domestic equity markets in January and February, with the S&P 500 Index up 9% on a total return basis through the end of last month, investors continued to shun actively managed U.S. stock funds, pulling out more than $10 billion during the first two months of 2012. The outflows from actively managed U.S. stock funds weren't as bad as in the third and fourth quarters of last year (when investors pulled out $49 billion and $46 billion, respectively), but still a far cry from the more than $15 billion that flowed into these funds during the first quarter of 2011. Meanwhile, flows into U.S. stock index funds and exchange-traded funds look to be on par with what we were seeing in the year-ago period, with $7 billion and $14 billion, respectively, flowing into these passive investment vehicles. Flows into international stock funds have also picked up pace so far in 2012, unencumbered by some of the events--like the Japanese earthquake/tsunami and the start of the Arab revolts--that derailed flows in the first quarter of last year. Overall, though, investors continue to favor passively managed investments when putting money to work in equities--a trend that has been in place for U.S. equities since 2005, and one that kicked in for international equities during 2008.
This trend continues to benefit the two asset managers we cover that have a stronger presence in the passive investment channel: BlackRock (BLK) and Invesco (IVZ). Based on information provided by Morningstar Direct, BlackRock picked up another $2 billion in inflows into equities with its iShares ETF business last month, with nearly $7 billion flowing into equity ETFs (70% U.S. stock/30% international) since the start of the year. This is about the same amount of investor capital that BlackRock has picked up year to date through its fixed-income ETF offerings, which (based on the continued flood of capital going into fixed-income funds) is saying something. While the industry giant has also seen more money flow into equity index funds this year, BlackRock is seeing an even larger amount of investor capital work its way into actively managed equity products.
Meanwhile, Invesco has seen more than $5 billion flow into its PowerShares ETF business since the start of 2012, with the majority of that capital being directed at funds dedicated to U.S. stocks. This more than makes up for the outflows the firm continues to see from its actively managed domestic stock funds and adds some additional color to management's comments during the fourth-quarter call about Invesco seeing an increased interest in equities in the early part of 2012. With the overall trend of fund flows in the asset management industry continuing to favor ETFs and other passive investments over actively managed equity strategies, we think BlackRock and Invesco have a meaningful leg up over their peers. While Franklin Resources (BEN) does not have much of a presence in passive investment products, it makes up for it with a portfolio that is more global in nature, with more than half of its AUM invested in global/international strategies and one third of managed assets sourced from clients domiciled outside the United States. Even so, Franklin pulled in more with its U.S. stock fund offerings than it did with international equities offerings through the first two months of the calendar year.
The biggest losers here continue to be the more equity-heavy names we cover that have a heavier focus on U.S. equities and don't offer investors a compelling enough reason to invest with them. This makes these firms far more reliant on market appreciation to drive gains in their level of assets under management. Of the companies we cover that fit this bill, Janus Capital Group (JNS) stands out, as a string of really poor performances from both its U.S. and international stock funds over the past year and a half continues to drive meaningful outflows from the equity side of its business. Not surprisingly, the one winning asset class for Janus over the past three years has been fixed income, which has driven more than $12 billion in net inflows for the firm (which had just $3 billion in fixed-income AUM at the end of 2008).
Taxable Bonds Continue to Dominate Fund Flows
From the start of 2009 until the end of 2011, more than $550 billion flowed into actively managed taxable bond funds, with another $190 billion being dedicated to passively managed products (45% index funds/55% ETFs). Based on results seen through the first two months of this year, with $20 billion flowing into actively managed taxable bond funds during January and another $24 billion coming through in February, it looks like 2012 could end up being the fourth straight year when flows into the taxable bond category far outstrip those for any other category tracked by Morningstar Direct.
Inflows into intermediate-term bond funds have dominated the inflows into taxable-bond funds over the past three years. The trend has not changed all that much in 2012, as more than $15 billion flowed into the category last month, increasing the total inflows into intermediate-term bond funds to more than $28 billion during the first two months of the year (representing more than 40% of total inflows into taxable bonds in 2012). The flows into the category this year have been split among actively managed funds (60%), index funds (30%), and ETFs (10%).
Another beneficiary of investor inflows has been high-yield bond funds, which picked up more than $7 billion in February and have seen more than $17 million flow in since the start of the year. The amount of assets dedicated to this category has increased from $90 billion at the end of 2008 to more than $218 billion at the end of last year, as investors have had to move up the risk spectrum in order to pick up additional yield. While there were a couple of months in the back half of 2011 when investors bailed on the category (with August seeing the worst level of outflows), inflows have been at a much more elevated pace since the end of the third quarter.
We continue to believe that this trend benefits not only the more broadly diversified asset managers--BlackRock, Invesco, and Franklin Resources--but also some of the other firms we cover that have ramped up their fixed-income efforts over the past couple of years, with Janus and AllianceBernstein (AB) standing out from the pack. The real loser here has been Legg Mason (LM), which has failed to capitalize on the trend toward fixed-income assets over the past three years. With more than $550 billion flowing into actively managed taxable bond funds over the past three years, it has been troubling to watch Legg Mason lose more than $115 billion in fixed-income AUM to outflows since the start of 2009.
Municipal Bond Funds Post Increasingly Stronger Flows
Investors have also been warming back up to municipal bond funds, which saw a record level of outflows in late 2010-early 2011 in response to Meredith Whitney's prediction of hundreds of billions of dollars of municipal-bond defaults. While there were (and continue to be) some troubled areas in the tax-free fixed-income markets, given that there was not a tidal wave of defaults (and that most of these funds were down so hard at the end of 2010), it was no surprise to see the category up nearly 11% last year on a total return basis, with inflows exceeding $5 billion in December 2011--the strongest monthly flows since August 2010. That level of enthusiasm continued into 2012, with more than $6 billion flowing into the category in both January and February of this year.
While some of this can be the result of performance chasing, we think the majority of the interest in the category is coming from investors looking to hedge their exposure to a potential increase in personal income taxes, which is a real possibility as the Bush era tax cuts are set to expire at the end of this year and we see repeated calls from some politicians for capital gains to be taxed at the same rates as ordinary income. The biggest beneficiary of the interest in tax-advantaged strategies should be Eaton Vance (EV), which has carved out a successful niche providing equity and fixed-income investments to tax-sensitive clients. That said, the firm has picked up most of its fixed-income inflows from high-yield bond funds of late, with near-term underperformance at Eaton Vance Large-Cap Value, its flagship equity product, actually driving outflows that mute the impact of its gains on the fixed-income side of the business.
Risk-Aversion Cycle Favors More Broadly Diversified Asset Managers
For much of the past three years, we've been convinced that the asset managers are caught in a risk-aversion cycle in which investors gradually increase their risk appetite during stable and expanding markets, only to pull back dramatically during broader market declines. Given the impact that these wholesale exoduses can have on an individual asset class, we continue to prefer the more broadly diversified asset managers during this market cycle, especially those with solid equity and fixed-income franchises, with extra credit going to those with ETF platforms--like BlackRock and Invesco--or strong international franchises--like Franklin Resources. Aside from T. Rowe Price (TROW), which is a flow-generating machine, these three diversified firms have seen the strongest inflows so far in 2012.
BlackRock. The diversity of BlackRock's product offerings, which are almost equally split between actively managed and passive strategies, and the stickiness of its asset base put the firm in a unique position to gather and retain assets regardless of the market conditions. The firm looks to be hitting its stride in 2012, with flows coming in across its various asset classes, including actively managed U.S. equities. We believe BlackRock has one of the widest economic moats in the asset management industry, and we expect that moat to expand as the firm takes full advantage of market volatility to gain share.
Invesco. With a product portfolio that is fairly diverse by asset class, distribution channel, and geography and a stronger ability than most to generate internal growth, Invesco remains an attractive idea for long-term investors. At less than 14 times the consensus earnings per share estimate for 2012 (and less than 12 times the consensus figure for 2013), the firm is trading at about a 10% discount to its peers, when the shares have traditionally traded in line with the group--and should, in our view, be trading at a slight premium. With its legacy operations firing on all cylinders and the cross-selling opportunities created by the Van Kampen deal, Invesco is uniquely positioned to generate inflows in an environment where internal growth has been hard to come by.
Franklin Resources. Franklin's strong relationship with financial advisors and solid outperformance from Templeton Global Bond and Templeton Global Total Return this year have eased concerns about outflows from the firm's fixed-income franchise, which has been the biggest driver of its internal growth over the past three years. Through the first two months of 2012, investor flows for both funds remain in positive territory, but are still well off the monthly run rate we were seeing before the third quarter of 2011. As Franklin has traditionally generated the majority of its sales in any given period from just a handful of funds, it will always face the risk that underperformance from any one of these funds would affect investor flows. However, the diversity of its portfolio by asset class, distribution channel, and geographic reach will always help the firm to balance out shocks that might occur in any one part of its business.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade 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.