Tips From Donna Gordon (June 2016 Wesban Monthly)
by Donna Gordon on July 21st, 2016

Asset Flows Into Passive Bond Strategies Pick Up

Indexing or passive investing started out and is more predominant in equity funds.  Equities trade on an exchange, they're very liquid, and therefore they are relatively easy to index. On the other hand, bonds are traded over the counter, are not as liquid, trade less frequently, have higher trading costs, and there are also many more bonds out there than stocks. For these reasons, indexing fixed income is more difficult; however, fixed-income indexing has been growing rapidly in the last few years.
Looking back to 2008, passive fixed-income funds held 13% of assets. From 2008 to 2013, the category enjoyed steady positive flows as investors remained in flight-to-safety mode even after the financial crisis ended. Most of these flows went into active funds until the so-called 'taper tantrum' of 2013 caused a sudden reversal.
As investors began to plan for lower bond returns due to the Fed's tapering of the QE program, they became particularly sensitive to cost. Before, when an active manager had the potential to bring in higher returns, investors were willing to pay a larger fee. Now, however, if they know they have to settle for lower bond returns, investors started looking for less expensive options. So, in this context, the passive share of fixed-income assets doubled, from 13% in 2008 to 26% in 2015.
In conclusion, fixed-income flows are very sensitive to interest-rate movements, and investors are positioning themselves for a low-return world while trying to control costs. This will continue to be an interesting story going forward because there is still uncertainty about when and by how much rates will increase, and that is likely to keep flows volatile for most fixed-income categories.
​Low-Volatility ETFs

One trend we've been observing recently is increasing flows into low-volatility exchange-traded funds. Currently there are 18 low-volatility ETFs in Morningstar's database, with $23 billion in assets as of May 13, 2016. The largest funds in this category are iShares MSCI USA Minimum Volatility and PowerShares S&P 500 Low Volatility.
These ETFs aim to provide similar returns to the U.S. stock market, while at the same time taking on less risk than the overall market. Obviously, that's an appealing concept for investors, especially after the January sell-off. Investors are still seeking exposure to U.S. equities but are less and less willing to put up with the market's erratic ups and downs.
Looking at monthly organic growth rates (that's flows over beginning assets), we can see that low-volatility ETFs grew at a peak rate of 17% in February and continued to grow at a robust pace since. In contrast, the organic growth rate for SPDR S&P 500 SPY was a negative 1% in February and remained close to zero for the next two months. Flows tend to follow performance, and low-volatility ETFs significantly outperformed SPY, on average, both year to date and during the past year.
A word of caution, however. Like any rapidly accelerating trend, the growing popularity of low-volatility ETFs carries some concerns. These ETFs are more expensive; their average expense ratio is 29 basis points, as opposed to only 9 for SPY. Also, there are concerns that low-volatility ETFs may now be overvalued after such large inflows and will not able to maintain such high returns in the future. Investors should carefully consider the potential downsides, as well as the benefits, before jumping in on this trend.
Investor Return Versus Total Return

The average investor return can diverge widely from a fund's posted total return, illustrating the dangers of performance chasing. The Morningstar Investor Return data point measures how the typical investor in a fund fared over time, incorporating the impact of cash inflows and outflows. It is not one specific investor's experience, but rather a measure of the return earned collectively by all investors in the fund. Conversely, total return measures the percentage change in price for a fund, assuming the investor buys and holds the fund over the entire time period, reinvests distributions, and does not make any additional purchases or sales.
The image illustrates the divergence in total return and investor return for a mutual fund selected from Morningstar's mutual fund database. The fund's 10-year total return was 3.9%, but its 10-year investor return was a terrible negative 15.4%, which is quite a big difference. The fund's net cash flow tells the story of the discrepancy. Investors piled into the fund during its runup between 2006 and mid-2007, with most inflows occurring near the fund's peak value. Investors then fled as the fund's returns plummeted, with most outflows occurring near the fund's bottom. This type of behavior is not uncommon as investors tend to chase performance, buying high and selling low.
In conclusion, performance-chasing is one of the biggest reasons investors underperform over the long term. By being aware of this behavioral bias, you can be better prepared to counteract it, by learning to stick to a long-term asset allocation plan through the market's ups and downs.

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