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Great Rotation? Not Quite


Equity and bond mutual funds alike started off the new year with a bang, bringing in $86 billion in fresh assets. This combined with $29 billion flowing into exchange-traded funds was by far the largest one-month gain on record for mutual funds, according to Morningstar.

The signal event: $19 billion flowing into domestic stock funds. Why? Because investors took $610 billion out, from 2007 through 2012, according to Investment Company Institute statistics. But whether this indicates the beginning of a "Great Rotation" away from bond funds remains to be seen.

Bank of America Merrill Lynch Chief Investment Strategist Michael Hartnett says it is. But he has been making the case for a couple years now.

"While sentiment toward equities has picked up in recent weeks, individual investors have been overwhelmingly pro-fixed income and anti-equities over the last two years,'' he argued in his Research Investment Committee Monthly Investment Overview in January 2011. "In 2009 and 2010, fund flows into fixed income funds as a percent of assets under management totaled a massive 19% and 10%, respectively. The outperformance of equities over the same two-year period and the stark contrast between the health of the corporate and government balance sheets are likely to cause rotation out of bond funds into equity funds in 2011."

On January 25 of this year, he wrote: "The past 13 days have seen $35 billion come back into equity funds ($19 billion of which is via long-only). And while the industry flow data does not show 'rotation' out of bonds, our private client data does. The structural long position in fixed income (funds) is simply threatened by low expected returns thanks to low rates and the mathematical reality that a small rise in rates can cause total return losses in portfolios."

The $19 billion inflow to U.S. stock funds, the largest since 2004, plays into that story says Michael Rawson, fund analyst, Passive Funds Research at Morningstar. So does the strength of flows into active U.S. stock funds, which recorded their first inflow in 23 months.

"[However], if you look at the 'Great Rotation' story, investors didn't really sell bonds; they actually put a lot of money into bonds," said Rawson. In fact, investors pumped $31 billion into taxable bond funds, according to Morningstar.

"Money was going everywhere and most of it ended up in bond funds. But stock funds did do well because they've been doing so poorly in the past. A lot of money also went into diversified emerging markets. For the past several months, inflows in general have been strong but they were just really stronger last month," said Rawson.

"Great Rotation" aside, Rawson attributes January's equity fund flows to the fact that equity flows are generally stronger in January than later in a year. At the end of last year, for instance, a lot of mutual fund companies pre-paid dividends for fear of the fact that dividend tax rates might go up if the U.S. government over the fiscal cliff. "So some of the money that came into the market in late December and early January were just reinvestments of these early dividends," he said.

Rawson said investors' also were looking for higher yields, taking money come out of government bond funds and putting them into risker bond funds such as the PIMCO Income Fund and the PIMCO All Asset All Authority Fund.

Going forward, Rawson expects investors will continue their allocations to equities funds and flows to bonds will weaken a bit because of the dwindling return potentials in bonds, with 10-year Treasuries at 2% and 30-year Treasuries at 3.19%, according to Robert W. Baird & Co.

"Emerging market bond and corporate bond yield spreads have come down quite a bit so there's not much return potential in bonds. I don't think we're going to see strong flows into bonds like we've seen in the past. I think some of that money is probably going to go into equities," Rawson said.

Investors' sentiments in January were buoyed by a host of factors including more political and financial certainty, according to Avi Nachmany, Strategic Insight's Director of Research. "January flows data suggests that post-election assurance of political stability and tax rates combined with rising home prices, falling unemployment, and fading memories of 2008 have helped investors overcome, at least for now, a state of investment anxiety," he said.

"As economic life across America slowly improves, investment in stock funds will increase too,'' he said. "Over 80% of all stock fund balances are dedicated to retirement savings, thus having accumulation and withdrawal time-horizons of 20, 30, or 40 years for many investors. As Americans become more confident about the future, investing for retirement through stock mutual funds will expand."

By the research firm's own estimates, stock and bond mutual fund net inflows reached and possibly exceeded $90 billion last month. Some $51 billion, or more than half, of the January flows went into stock and balanced mutual funds, marking the largest monthly amount in more than a decade.

Nachmany is also not yet a subscriber to the "Great Rotation" theme.

"Naturally, some of the January net inflows are seasonal deposits early in the New Year, as well as reversals of tax-selling redemptions of December. But most January inflows are from hesitant investors again voting their dollars, now and likely in future months, into stock funds," he said.

For January 2013, Strategic Insight estimated that net inflows to bond funds exceeded $40 billion, significantly above 2012's average monthly flows to bond funds of $27 billion. Strategic Insight projects bond fund inflows to persist in the coming months, as investors holding $10 trillion of cash slowly search for income opportunities elsewhere.


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