By Gregory Warren, CFA
While global equity markets have regained some of their footing during the third quarter, we don't believe this signals an end to market volatility. With Europe dealing with what has become an expanding debt crisis, most developed economies around the globe struggling to maintain any kind of positive momentum, and growth in emerging and developing markets like China and Brazil stumbling as a result, we don't see much that will change what has been a macro-driven market for investors. We believe that this ongoing volatility has caused investors to rapidly alter their risk tolerances and asset class preferences in response to short-term news and investment performance. As such, we favor the more broadly diversified asset management firms, especially those that offer a mix of active and passive strategies, strong equity and fixed-income franchises, and exposure to both domestic and international markets, during periods of market volatility. We continue to highlight the asset managers we cover that have solid exchange-traded fund platforms -- like BlackRock (BLK) and Invesco (IVZ) -- or strong international franchises -- like Franklin Resources (BEN) -- which we think are much better positioned than their peers to hold on to assets in this more volatile market environment.
Outflows Continue for Actively Managed U.S. Stock Funds
Despite gains in the U.S. equity markets, as represented by the S&P 500 Index during June (up 4.3%), July (up 1.0%), and August (up 2.3%), investors continued to pull money out of actively managed U.S. stock funds last month. This marks the 18th straight month of outflows from the category, leaving 2012 on pace to match the level of investor outflows that were recorded last year, which at $97 billion were second only to the nearly $115 billion that flowed out during 2008. We believe this is the most likely scenario for actively managed U.S. stock funds, given that flows for the category, according to data provided by Morningstar Direct, have been negative in the back half of each of the past six calendar years (with only two months popping up during that entire time -- December 2006 and August 2008 -- where flows for actively managed U.S. stock funds were actually positive).
The impact that the massive outflows at American Funds has had on these results, though, should not be ignored. While the flow results for actively managed U.S. stock funds are still negative after stripping out the results from the struggling fund firm, the results at American Funds -- which are heavily influenced by the flow results at American Funds Growth Fund of America -- have had (and continue to have) a profound impact on the overall flow picture. In many ways, the story at American Funds mirrors those we've seen unfold at Legg Mason (LM) and AllianceBernstein (AB). All three asset managers came into the 2008-09 financial crisis overseeing a significant level of assets under management, with American Funds at $1.1 trillion, Legg Mason at $1 trillion, and AllianceBernstein at $800 billion. All three generated solid investor inflows in the five years leading up to the financial crisis, with American Funds and AllianceBernstein seeing gains based on the long-term record of their equity funds. And all three asset managers saw investment performance falter during and after the financial crisis, which led to massive outflows over the next several years -- with Legg Mason affected more heavily on the fixed-income side of the business and American Funds and AllianceBernstein dragged down by outflows from their equity offerings. What has differentiated American Funds from its peers, though, is that its outflows were centered in the retail channel, while Legg Mason and AllianceBernstein saw the majority of their outflows coming from institutional investors (with the activity of this particular channel not always fully reflected in Morningstar's U.S. open-end, ETF, and money market data).
Much as stripping out the impact of American Funds from the overall flows of actively managed U.S. stock funds provides us with a much clearer flow picture for the segment, so too does breaking out the impact that State Street's (STT) SPDR S&P 500 fund has on the results for exchange-traded funds that are dedicated to domestic stocks. The SPDR S&P 500 fund is an institution in and of itself. It moves much more heavily with movements in Chicago Board Options Exchange's VIX and tends to have a big impact on the month-to-month flow data in periods of greater market volatility (which we've seen on and off again for much of the past five and a half years). Because of the influence the SPDR S&P 500 fund has on flows, we've seen the data for U.S. stock ETF flows doing counterintuitive things during more volatile markets -- with inflows at times increasing during market declines and outflows accelerating during rallies.
By looking at the flow data through this lens, we see that investor flows into ETFs dedicated to U.S. stocks during the month of August fell off the fairly torrid pace of June and July, which could be a sign that the U.S. markets are heading for another correction (as we saw this same pattern emerge in April/May after strong inflows into domestic stock ETFs were recorded in February/March). It also looks like Vanguard continues to take the majority of the inflows coming into ETFs dedicated to U.S. stocks, picking up more than $3.2 billion during the month, compared with BlackRock's iShares at $1.7 billion and Invesco's PowerShares at $670 million. Despite the impact of the SPDR S&P 500 fund, which recorded $7.1 billion in outflows during August, State Street saw just $5.5 billion in total outflows from its domestic stock ETFs last month. It also looks as if overall flows have recovered somewhat during September, with the category seeing $3.8 billion in inflows through the 12th of the month (after stripping out the $5.3 billion that flowed into the SPDR S&P 500 fund during that same time frame).
Actively Managed International Stock Fund Flows Continue to Falter
Much as it has affected the results for actively managed U.S. stock funds, American Funds has also influenced the flow data for actively managed international stock funds. Stripping out the impact that the asset manager's outflows have on the overall results, it appears that flows remained in negative territory during August, even with the MSCI EAFE Index posting equally as strong returns as the S&P 500 over the past three months. The outflows are also on par with the levels seen during July and August last year, when there were far more visible reasons for investors to pull capital out of international stock funds. That said, with Europe dealing with what has become an expanding debt crisis, most developed economies around the globe struggling to maintain any kind of positive momentum, and growth in emerging and developing markets like China and Brazil stumbling as a result, it is not as though investors are lacking reasons to be more cautious right now. Still, flows for passively managed international stock funds have remained relatively robust, with diversified emerging market funds -- which have seen more than $19 billion in investor inflows so far this year -- continuing to be the biggest draw of investor attention, and the Vanguard Emerging Markets Stock Index fund still seeing the lion's share of the inflows. Looking at the flow data through the first 12 days of September, it does look like overall flows have recovered somewhat for the international stock fund category, with European stock funds actually leading the way.
Actively Managed Taxable Bond Fund Flows Back On Track
Flows into actively managed taxable bond funds, which had been on a torrid pace during the first three months of 2012 (averaging around $22 billion a month), dropped off fairly significantly during the second quarter, with total inflows of $17 billion during April followed up by even weaker flows of $8 billion in May and $9 billion in June. Flows picked up again during July and August, with the pace of flows matching what we were seeing earlier in the year. Much as we saw during the first quarter, flows into actively managed taxable bond funds outpaced those going into index funds and ETFs, with the total combined flows for the year (of $202 billion) surpassing what we saw last year and putting 2012 on pace to hit the level of inflows seen for taxable bond funds overall in 2010 (and, quite possibly, 2009). It does, however, look like taxable bond fund flows have moderated some during the first 12 days of September, with total flows barely exceeding $5 billion (which would imply total flows for the month in the neighborhood of $15 billion). Inflows into intermediate-term bond funds continue to dominate the flows going into both actively managed and passively managed taxable bond funds, with high-yield bond funds and short-term bond funds continuing to battle for that more distant second-place spot. It is also interesting to see flows into municipal bond funds remaining relatively robust, considering how much of a pariah they were during the first three quarters of 2011.
Flows for BlackRock's Actively and Passively Managed Funds Remain Positive
After a fairly dismal showing during the second quarter, BlackRock's iShares division bounced back in July and August, picking up its fair share of the capital that flowed into passively managed equity and fixed-income funds last month. The company also continues to see positive momentum in its actively managed funds, with outflows from its stock funds more than offset by flows into its cash management and fixed-income funds offerings. The big news for BlackRock this month, though, was the announcement that the firm will be lowering fees for some of its larger, more liquid core asset class ETFs, which is where iShares has been hit the hardest by Vanguard's ETF offerings. We expect the cost of this to be alleviated somewhat by BlackRock's rollout of its own internal trading platform, and we believe it is an essential move for the firm to ultimately be successful with its push into the retail channel, where Vanguard has been making the biggest inroads, especially with financial advisors. While BlackRock's shares are standing exactly where they were at the beginning of the year, and there has been plenty of volatility in the shares (which reached a high of $206 in early April before falling to a low of $163 in late May), we continue to recommend investors wait for prices in the $150-$160 range before making significant commitments. This was the same trading level that the shares dropped to during the third quarter of last year, when investors seemed unwilling to differentiate between the quality diversified asset managers -- like BlackRock, Invesco, and Franklin Resources -- and the more equity-heavy names on our list.
Investors Have Recognized the Strength of Invesco's Operations
Having spent much of the third quarter of 2011 pounding the table on Invesco, which was trading at single-digit multiples (despite the fact that its assets under management were holding up well in the face of declining global markets), it is refreshing to see its common stock now trading more in tandem with BlackRock and Franklin Resources, which we think are its two most comparable peers. Invesco continues to add to the positive impression that it has seemingly gained with investors by posting positive inflows across both its actively and passively managed AUM. The company recently noted that its managed assets reached $670 billion during August, just shy of the record level of $673 billion in total AUM that Invesco reported at the end of March 2012. We firmly believe that Invesco is firing on all cylinders, and given the cross-selling opportunities that have been created by the Van Kampen deal, we believe the company is uniquely positioned to generate inflows in an environment where internal growth has been hard to come by for many of the asset managers we cover. With the firm's shares up nearly 30% year to date, there is not much room for its common stock to run in the current environment, in our view.
Muted Flows at Templeton Global Bond Limiting Franklin's AUM Growth
Even though Franklin Resources has seen a dramatic turnaround in the performance of Templeton Global Bond this year, flows into its global/international fixed-income operations remain fairly muted. Still, the company continues to pick up assets through its other fund offerings, reporting a nearly 2% increase in its total AUM last month, spread out fairly evenly among its equity, balanced, and fixed-income product lines. Of note, too, is the fact that the firm's managed assets reached $731 billion last month, putting Franklin's total AUM within shouting distance of the record level of $734 billion reached at the end of June 2011. Barring a dramatic downturn in the global equity markets this month, Franklin should close out fiscal 2012 (ending September) with $730 billion-$740 billion in total AUM. With the shares already up 30% since the start of calendar 2012 and trading at a slight premium to BlackRock and Invesco, it's hard to get too excited. We'd be buyers of Franklin's common stock, though, if it were to drop back down below $100, which was where it was trading during the third and fourth quarters of last year, when the global markets were in turmoil and investors were concerned about the impact that poor performance at Templeton Global Bond, as well as Templeton Global Total Return, would have on organic growth and AUM levels at the firm.
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.