Imagine you wake up one morning to find everything-actions, events, and outcomes-exactly the same as on the previous day. That was the premise for Bill Murray's character in the movie Groundhog Day, where no matter what decisions he made, the next day started as if he had done nothing at all the previous day. Although not quite as extreme, equity investors have seen a definite parallel since the beginning of 2011.

The first quarter of recent years started out spectacularly as U.S. equities rallied and brought the hope of growth to the market. Equity funds finished the first three months of 2011 up 5.14% on average-for their best first quarter return since 2006; this was despite the Japanese earthquake and the subsequent nuclear incident as well as the budding unrest in the Middle East.

Investors seemed confident in the equity markets, injecting roughly $48.7 billion into equity mutual funds. Unfortunately, these sanguine feelings did not last long. European sovereign debt concerns and the U.S. debt-ceiling debacle kicked off a level of market volatility not seen since the financial crisis of 2008. In the third quarter of 2011 alone, equity mutual funds posted a loss of 14.44% on average and, despite a strong rebound in the fourth quarter, ended the year down 6%.

Cue 2012. Coming off the strong fourth quarter 2011, the equity markets were able to build momentum through March of the New Year, with the S&P 500 closing the period up a whopping 12%. European debt concerns seemed to stabilize, and economic news in the U.S. appeared to be on the rise as unemployment numbers, retail sales, and durable goods orders moved in the right direction.

Investors had something to cheer about as equity mutual funds followed suit with a quarterly return of 11.97%, their strongest first quarter since 1998. The hope was that the U.S. economy was finally over the hump and that with muted volatility a sense of "normalcy" would prevail.

The reality was much different. The effects of the continuing debt issues in Europe resurfaced, with much of the attention shifting to Italy and, more importantly, Spain. Skyrocketing yields and the reality of a new recession in much of the Eurozone once again put downward pressure on the markets, erasing nearly a fifth of the gains from the first quarter.

So here we are into the second half of 2012, and the concerns that have been plaguing the domestic and international markets remain. Lackluster growth, widespread unemployment and a looming debt crisis overseas continue to challenge the equity markets. Combine that with the upcoming presidential election and the effects of previous questionable policy decisions on the markets, and the short-term future seems even more uncertain. Short-term volatility has put stress on both investors and advisors alike.

Risk positions such as equities are usually seen as an integral part of a portfolio, especially for investors with a longer time horizon to (and through) retirement.

However, the truth is that confidence in equity funds has waned. U.S.-registered equity mutual funds have seen net redemptions of approximately $250 billion since August 2008. Bond funds (excluding money market products) have been the beneficiary of such aversion, pulling in nearly $770 billion of net inflows during the same period.

So where to go from here? Although it's an option for the short term, many would not advise that an extremely overweighted portfolio of fixed income would be the right choice for the medium to long term. Eventually, as we have been hearing for years now, inflation and yields will rise.

One answer for equity fund investors seems to have been to turn heavily toward passively managed indexed products. The motivation, in part, may be the lower expenses of such funds, which in turn relates directly to bottom-line performance. Simply put, when in doubt you buy the market as a whole or segments of the market, depending on your desired sector and global allocation.

Through Q1 2012 alone, index-based equity mutual funds have garnered roughly $31.3 billion of net new flows. This compares to outflows of roughly $51.2 billion from actively managed products during the same period-clearly showing a heavy preference for index funds by both investors and advisors.

While index investing may be a great way to get beta exposure, there will continue to be demand for higher performance than the broad equity market is providing. One way to get this performance is to focus on what many see as an integral part of equity investing: funds that have a strong underlying exposure to dividends. While this is not a new strategy by any means, we have seen for some time an overweighted focus toward capital appreciation. Whether driven by the financial news cycle or the desire to get exposure to the next Google or Apple, investment decisions have often focused on the potential for growth. The focus on achieving total return through strong and consistent income dividends has often taken a back seat to this quest for capital gains.

With the market volatility we have seen over the past few years, a shift toward dividend-producing funds has started. Not only is this focus due to some wariness about growth-focused products, but near-record lows in fixed income yields relative to equity yields have started to push investors' attention back to equity as an income provider.

Recently, we have seen that equity-dividend plays have garnered both strong inflows and total return. For both mutual funds and ETFs certain dividend-seeking strategies have caught the attention of investors; equity income, real estate, and natural resources-based products have provided attractive yields (2% plus) as well as strong performance relative to the market (see the chart above). Global and international income funds over the trailing 12-month period as of June 30, 2012, have provided a weighted average yield of over 4.6%. Paired with strong yields in real estate-and natural resources-(heavily bolstered by master limited partnership structured products) fund investors have taken notice, allocating $25.8 billion to these groups.

Since current market concerns appear to be far from resolved, it might be safe to assume that, on the whole, investors will continue to show caution toward allocating themselves fully back to previous levels in equity funds. Income-focused equity products may continue to be an attractive way to add long-term consistency through income in an environment where volatility and market news are driving short-term decisions.

Overall, income generation is a strategy that can be achieved through other assets besides bonds and can be well diversified amongst sectors and regions. However, this will depend on the individual investor's goals, risk profiles and tax situations.

 

Matthew Lemieux is a research analyst for Lipper. He specializes in performance analysis,
methodology management and fund flows and also contributes to Lipper FundFlows Insight.