After seeking other avenues to put their money to work during the five-year period following the 2008 financial crisis, investors have flocked back to equity mutual funds over the last 18 months. During the 2008-2012 timeframe, equity funds had average annual net outflows of roughly $86 billion, while taxable bond funds had average annual net inflows of more than $193 billion. Equity fund net outflows peaked at $200.9 billion during 2008, the year of the financial meltdown, and investors did not completely embrace equity funds again until 2013, when net inflows of more than $194 billion went into equity funds. Investors have continued to seek equity funds in 2014; equity funds year-to-date net inflows of $93.5 billion put their 18-month total at $287.9 billion.
The net outflows for equity funds from 2008-2012 were in direct contrast to the five-year period (2003-2007) preceding the Great Recession. During that time, equity funds had average annual inflows of more than $111 billion. Taxable bond funds also had positive net inflows during that time. Their results (net inflows of $84 billion per year on average) for that five-year period were comparable to their inflows over the past 18 months (total net inflows of $94.4 billion), but substantially less than their numbers when investors were looking for safe havens after the financial crisis.
The pivot to equity funds has been very concentrated. Over the past 18 months, the top 10 Lipper equity fund classifications by total net inflows account for 90.2% of all positive flows to the equity fund universe. Investors have shown an affinity for international equity funds during this time. (Lipper defines an international equity fund as one that is registered in the U.S. but invests the lions share of its assets in stocks that are domiciled outside the U.S.)
Lippers International Multi-Cap Core Funds classification, with positive net flows of more than $68 billion (23.6% of the universe), is at the top of the list, and four of the top 10 increases are found in international equity fund categories. International equity funds as a whole account for more than 56% of the total net inflows over this period.
While capturing 56% of the total inflows may not appear to be a significant achievement when taken on its own, that number gains weight if we consider the size of the international equity fund universe compared to that of the domestic equity fund universe. (Lipper defines domestic equity funds as those funds that are registered in the U.S. and that primarily invest in U.S.-domiciled stocks.) As of the end of June 2014, Lipper data shows that the domestic open-end fund universe is more than three times the size of the international fund universe, comparing assets under management ($5.2 trillion versus $1.6 trillion).
The same approximate disparity exists between the two universes if we explore the number of options from which to choose; the number of unique U.S. open-end equity funds totals approximately 2,500, while the number of international equity funds stands at roughly 800.
So the question arises: Although U.S. investors have started to regain their confidence in equities after the financial meltdown of 2008, why have they favored international equity funds over U.S. equity funds? Apparently, it has not been because of performance. For the year to date, the average U.S. equity fund has outperformed the average international equity fund, 6.1% to 4.7%. For the 18-month period ended June 30, 2014, the return for domestic equity funds on average is double (25.1% versus 12.5%) that of the average international equity fund.
Even the two international equity fund classifications with the largest net inflows have underperformed the domestic universe. International Multi-Cap Core Funds had on average returns of 0.3% and 1.2% for the year to date and since the start of 2013, respectively, while funds in the Emerging Markets category had returns of 5.7% and 3.9% on average for the two periods.
If not for returns, why else have U.S. investors poured money into international equity funds? There are several potential reasons: (1) international investing provides diversification of returns; (2) there is a potential for higher economic growth rates in emerging markets; and (3) investing in international stocks can be a contrarian play.
The fact that the size of the domestic open-end equity fund universe is more than three times the size of the international equity fund universe indicates that U.S. investors have traditionally favored investing at home. But international stock funds can be considered an essential part of a diversified portfolio. International stock funds provide diversification because U.S. and non-U.S. stocks are impacted by different economic circumstances, which in turn produce different returns. The increased net flows to international equity funds may be an indicator that investors are seeking to diversify their returns after the financial crisis.
Lippers Emerging Markets Funds classification grew $34 billion over the last year and a half, representing the third largest increase among Lippers equity fund classifications. Investors are attracted to emerging-market countries because growth rates there have been generally higher than for developed markets; in addition, those countries have higher potential for future growth.
But higher growth rates do not always translate to better fund returns. As referenced earlier, for the year to date the return for Emerging Markets Funds is 5.7%, which only slightly trails the average for all domestic equity funds (+6.1%). But when we look at the 18-month period, we find that the Emerging Markets Funds classification (+3.9%) significantly trails domestic equity funds (+25.1%). While emerging markets have the potential for more economic growth than do developed markets, the risks that can impact performance are also more amplified in emerging markets.
Europe: Contrarian Target
Europes mounting public debt and reduction in economic growth has made the region a target for contrarian investment strategies. The three international diversified equity fund classifications (International Multi-Cap Core, International Large-Cap Core and International Multi-Cap Growth) that are among Lippers top 10 categories for net inflows all invest the majority of their assets (more than 58% on average) in European equities, making them potentially attractive to contrarian investors. These three fund classifications represent over 61% of the total net flows (+$99.7 billion) into international equity funds since the start of 2013.
The net inflows for international equity funds have not slowed this year despite the geopolitical unrest the U.S. has encountered during the first half of 2014. For the year to date, international equity funds have taken in more than $57 billion, keeping the group on pace to match or exceed last years total net inflows of $105 billion. This data verifies that U.S. investors have not backed off their recent demand for international equity funds despite ongoing geopolitical conflicts.
Patrick Keon is a Lipper research analyst specializing in U.S. fund classifications and portfolio analytics.
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