By Greggory Warren, CFA
While the first quarter was exemplified by strong equity markets, with the S&P 500 Index seeing more than 12% on a total return basis, there were signs of trouble in the first couple of weeks of April, as the markets turned south in response to concerns about corporate earnings, quantitative easing, and the European debt crisis. Surprisingly enough, outflows from actively managed U.S. stock funds were not as dire in April as they were in March--a sign, in our view, that investors were moving out of equities in anticipation of a downturn. We continue to believe the asset managers are caught in a risk-aversion cycle, with investors gradually increasing their risk appetite during stable and expanding markets, only to pull back dramatically during broader market declines. With the U.S. markets, as exemplified by the S&P 500, down more than 5% since the end of the first quarter, we expect to see equity redemptions picking up even more steam in May. Given the impact that an exodus of this nature can have on an individual asset class, we continue to prefer the more broadly diversified asset managers, especially those with solid equity and fixed-income franchises, to firms with a more singular focus. In our view, firms with exchange-traded fund platforms--like BlackRock (BLK) and Invesco (IVZ)--or strong international franchises--like Franklin Resources (BEN)--are much better positioned to hold on to assets in this environment.
Investors Pull Money Out of Both Actively and Passively Managed U.S. Stock Funds
Although we think the less dire outflows in April versus March showed that investors were moving out of equities in anticipation of a downturn, it could just be another sign of investor fatigue with the underperformance levels of actively managed funds. Less than one fifth of U.S. large-cap stock fund managers beat the S&P 500 during 2011, so it could be that investors saw an opportunity (with the markets running up double digits during the first quarter) to walk away on a high note from funds that had not met their expectations. Flows for both index funds and ETFs also turned negative during April, something we've not seen since the sell-off in August/September of last year.
Looking more closely at the distribution of assets within the U.S. stock fund category over the past decade, it is evident that index funds and ETFs have been gaining share, but this has not been coming entirely from actively managed stock funds. The data provided to us by Morningstar Direct demonstrate that actively managed U.S. stock funds continue to hold their own, despite the impact of poor performance and outflows, especially over the past five years. CEO Larry Fink of BlackRock, which owns the largest ETF platform--iShares--in the United States, has said many times that he has seen no evidence that ETFs are cannibalizing the mutual fund business. His take is that the industry as a whole has seen a significant increase in the use of ETFs, with many investors using what typically have been viewed as beta products to generate alpha. He sees the product being used more for tactical allocation purposes--to get greater exposure to an asset class or a geographic region--than as a substitute for actively managed funds. Much of the capital he sees coming into ETFs is from new participants in these products, with institutional investors being the largest contributors to the inflows.
Not only does the growth of ETFs far outstrip that seen at actively managed U.S. stock funds, which have been in net outflow mode since 2007, but U.S. stock index funds as well, which we think have been cannibalized by ETFs, as they offer greater liquidity at a lower cost than most index funds. Also, the outflow problem among actively managed U.S. stock funds has been fairly broad-based, with the only inflows seen over the past five years coming through small- and mid-cap funds. While large-cap funds have been the main detractors, some of the contribution needs to be put in context, especially with regards to the large-cap growth category, which is being distorted by what has been going on at American Funds Growth Fund of America. With more than $126 billion in total assets under management at the end of April, it is not only the single-largest large-cap growth fund in the industry, but it also has been the largest contributor to outflows for the category, having seen more than $60 billion in net redemptions since the start of 2009. As this one fund has accounted for close to one fourth of the more than $256 billion that has flowed out of actively managed U.S. stock funds over the past three-plus years, we think it is important to consider this before passing judgment on the overall category. That said, the trend continues to favor passively managed strategies--index funds and ETFs--over actively managed U.S. stock funds. As such, we continue to favor the two asset managers we cover that have stronger presences in the passive investment channel: BlackRock and Invesco.
One interesting development on the actively managed side of the business was the purchase of Yacktman Asset Management last month by Affiliated Managers Group (AMG). Exemplifying its positioning as the buyer of choice for some of the best boutique asset managers in the world, AMG took an equity stake in the father-and-son management team behind the Yacktman and Yacktman Focused funds. These two funds have not only been top long-term performers, with both ranked in the top decile of Morningstar's Large Value category over the past 3-, 5- and 10-year periods, and each garnering 5-star fund ratings from our fund analysts, but have generated more than $11 billion of net inflows since the start of 2009--a rarity among actively managed U.S. stock funds. We think this is a huge win for AMG, which expects to use its Managers Investment Group distribution platform--which already houses well-known brands like Tweedy Browne and Third Avenue--to increase the reach (and inflows) of the Yacktman funds. This should not, however, be viewed as the start of a period of increased merger and acquisition activity for the industry, as this was a bread-and-butter transaction for AMG (whose primary business model revolves around the acquisition of equity stakes in boutique asset managers), and there are not too many properties out there like Yacktman that we believe would be willing to be part of a larger asset management firm, especially those within our coverage universe.
International Stock Funds Still Garnering Interest
Despite rising concerns about Europe, money continues to flow into international stock funds, with most of the capital dedicated to actively managed and index funds. Diversified emerging-market funds continue to be the most popular destination for investors, capturing close to $60 billion of net inflows over the past year alone, with world stock and foreign large-cap funds rounding out the top five generators of investors' flows. The biggest winners in this category more recently have been Vanguard, Dimensional Fund Advisors, John Hancock, PIMCO, and T. Rowe Price (TROW). More notable omissions have been Franklin Resources and Invesco, which have fairly decent international stock operations, but just aren't generating the level of flows that the top fund companies are right now. One firm we cover that is seeing a fair amount of flows from its international stock fund offerings is AMG, which has benefited from the strength of its Harding Loevner and Tweedy Browne affiliates. The company remains well positioned, with 3 of the top 30 emerging-market managers in its stable and a commitment to not only building out the investment capabilities of these funds, but their global distribution as well (much like it expects to do with the Yacktman funds).
Taxable Bonds Continue to Dominate Investor Fund Flows
As has been the case for much of the past three-plus years, taxable fixed-income funds continue to garner the lion's share of investor attention. While total inflows of close to $22 billion (77% active/23% passive) during April were down from the $32 billion monthly run rate seen during the first quarter, investors have thrown $120 billion at the category year to date, putting it on pace to match the record level of inflows (of $328 billion) seen in 2009. Even if interest in taxable bond funds wanes this year, the industry could still see close to $200 billion in net inflows, making it the fourth straight year of flows of this magnitude into the category. While there is plenty of talk right now about a bond bubble, and we would be hard-pressed to dispute the notion that bond values will go down once interest rates start rising, we think the magnitude of the decline in bond values may end up being somewhat less than current forecasts. An aging baby boomer generation has prompted a move to more income-producing instruments on the retail side, with more volatile equity markets also leading many other investors (who are not necessarily concerned about income generation) to pare their exposure to stocks and stock funds. We've also heard plenty of instances where defined benefit plans (with a better feel for their longer-term liabilities) have locked in significant portions of their portfolios with fixed income, choosing to plug any differences that may arise with capital infusions rather than risk the volatility of the markets over the remainder of what has become an ever-decreasing obligation stream.
As for the more recent flows into the asset class, inflows into intermediate-term bond funds continue to dominate the flow picture. Total inflows of $7 billion lifted the total take for intermediate-bond funds to $46 billion year to date, with more than $130 billion flowing in over the past year. The category continues to account for 40% of total inflows into taxable-bond funds, with the majority of the capital going into actively managed funds. PIMCO, DoubleLine, Vanguard, J.P. Morgan, and T. Rowe Price have been the largest flow generators most recently, but BlackRock's iShares operation continues to hover around the edges. Other areas producing solid inflows of late have been the short-term bond ($5 billion during April), high-yield bond ($3 billion), and emerging-markets bond ($2 billion) categories. While not quite emerging-markets bond funds, Templeton Global Bond and Templeton Global Total Return, which tend to invest more heavily in currencies and emerging-market debt than more traditional global bond funds, continue to hold their own, which is good news for Franklin Resources. Both funds were up more than 7% during the first four months of the year, leaving them firmly in the top decile relative to their peers, a complete turnaround from the bottom-decile positioning each held at the end of last year. The improved performance, as well as all of the handholding that Franklin Resources and financial advisors have done this year, probably explains why both funds are generating positive flows so far in 2012 after falling into net outflow mode during the fourth quarter of last year.
Overall, we believe the trend toward fixed income will continue to not only benefit the more broadly diversified asset managers--BlackRock, Invesco, and Franklin Resources--but some of the other firms we cover that have ramped up their fixed-income efforts over the past couple of years, with Janus (JNS) and AllianceBernstein (AB) standing out from the pack. The real loser here continues to be Legg Mason (LM), which has failed to capitalize on the trend toward fixed-income assets over the past three-plus years. With more than $640 billion flowing into actively managed taxable bond funds since the start of 2009, it has been troubling to watch Legg Mason lose more than $140 billion in fixed-income AUM to outflows over the same period.
Risk-Aversion Cycle Continues to Favor More Broadly Diversified Asset Managers
For much of the past three-plus 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, which is a flow-generating machine, and Affiliated Managers Group, which has been one of only a few managers we cover capable of generating positive flows into actively managed equities, these three diversified firms are best positioned to capture solid investor inflows as we move through the remainder of 2012.
BlackRock. The firm had some positive momentum coming into the second quarter, picking up more than $17 billion (45% equities/55% fixed income) through its iShares ETF platform during the first quarter. Flows look to have weakened, though, on the equity side, with international stock ETFs seeing outflows during the period. While our data point to more than $3 billion in inflows for BlackRock during April, it looks like most of it was going into money market funds. The firm has also been under some pressure since announcing first-quarter earnings, when it was revealed that its institutional pipeline had declined sequentially from $54 billion to $24 billion. We're not overly concerned about this, though, as the strong runup in the equity markets during the first quarter probably gave institutional investors plenty of reasons to pause, and BlackRock at its core is primarily an institutional asset manager, which means that flows (when they do come) tend to be lumpier in nature than they would be for a firm with significantly more retail exposure in its AUM. While the company's shares are down more than 15% from the end of the first quarter, we'd wait for prices to drop to $150-$160 before making a significant commitment. This was the level the stock dropped to during the third quarter of last year, when investors were lumping more broadly diversified asset managers--like BlackRock, Invesco, and Franklin Resources--in with more equity-heavy names.
Invesco. Being one of only a handful of the managers we cover that actually reports its managed assets on a monthly basis, Invesco tends to be more of an open book than other names. The company closed out April with $668 billion in total AUM, down just 1% from the end of March. With Invesco having previously announced the loss of a $900 million actively managed fixed-income mandate in the United Kingdom, and noting that it had recorded $2.6 billion in outflows from its Invesco PowerShares QQQ ETF during April, we think this was a solid showing for the month. That said, the stock is down close to 20% since the end of the first quarter, and trading at 11.1 times this year's consensus estimate (and 9.4 times forward earnings estimates) makes it one of the cheapest names on our list. We continue to believe Invesco should trade more in line with BlackRock and Franklin Resources, which infers a stock price of $25-$26 based on current trading multiples for these two comparable firms. We'd still wait for prices below $20-$21 before taking a significant position.
Franklin Resources. With both Templeton Global Bond and Templeton Global Total Return outperforming their benchmarks by a wide margin so far this year, and both funds moving well into the top decile relative to their peers (compared with the bottom-decile position the funds found themselves in at the end of 2011), flows have returned to positive levels. While the flows for Templeton Global Total Return are looking closer to the $150 million monthly run rate seen in the year leading up to the third quarter of 2011, Templeton Global Bond remains well off the $1.6 billion monthly pace it had maintained before the market downturn. Both funds generated just over $100 million in positive flows during April, helping Franklin Resources to remain in positive flow territory for the year. That said, the shares have held up much better than just about every name on our list, declining just 9% since the end of the first quarter. We continue to recommend waiting until the shares drop below $100, which is where they were trading earlier this year when investors were overly concerned about the potential for significant outflows from Templeton Global Bond and Templeton Global Total Return.