Foreign intrigue: International equity funds lure investors

International equity funds continue to soak up investor cash while misery persists for actively managed U.S. stock funds. Investors pumped $26 billion into international equity funds in May, Morningstar Inc. said. Meanwhile, actively managed U.S. equity funds leaked $2.06 billion. That marked an improvement from April, when net outflows from actively managed U.S. equity funds totaled $18.2 billion, their largest monthly net outflows since July 2014. Those funds lost a record $151 billion in the 12 months ended April 30.

Year-to-date through May, international equity funds had netted $141.1 billion, with passively managed funds accounting for $105.6 billion of those inflows. By contrast, U.S. equity funds posted $45.02 billion of net outflows this year through the end of May, with passive funds attracting $15.9 billion and active funds recording $60.9 billion of net outflows.

Morningstar figures include both open-end mutual funds and exchange-traded funds.

E. Jeffrey Roof, president of Roof Advisory Group Inc., is among those boosting positions in international equity funds. The move is part of his strategy to reduce holdings that could be hurt by a stronger U.S. dollar. Dollar strength makes U.S. goods more expensive, reducing their appeal.

“About a year ago, we started to increase our foreign exposure somewhat notably,” said Mr. Roof, whose fee-only firm has more than $400 million in assets under management. Roof Advisory went from essentially “zero” in dedicated foreign equity exposure following the 2010 European financial crisis to about 7% to 10% of total equity currently.

All of Roof Advisory’s foreign equity exposure is in actively managed accounts, he said. In May, however, about 79% of international equity flows — or $21 billion — went into passive funds, according to Morningstar, consistent with the year-to-date trend.

“MAINSTREAM STRATEGY’

“Indexing is becoming a mainstream strategy in the international equity space,” Alina Lamy, a senior analyst at Morningstar, wrote in a report.

Rick Brooks, chief investment officer at Blankinship & Foster, a fee-only financial advisory firm with about $430 million in managed assets, has been moving away from actively managed U.S. domestic stock funds since 2008. Recently, he has begun to shift from active managers to passive investments on the international stock side as well, primarily using ETFs, so far.

“We work very hard to reduce the management fees and transaction costs in our client portfolios,” Mr. Brooks said, adding that the best way to do that is by using “passive or relatively passive” strategies such as index funds or funds like those offered by Dimensional Fund Advisors, which employs a systematic, research-backed approach designed to help it beat market benchmarks.

While actively managed U.S. stock funds surrendered $2.06 billion in May, passive funds — which include open-end mutual funds and ETFs that track indexes — registered $1.02 billion of net inflows, according to Morningstar.

Passively managed domestic equity funds have experienced just four months of net outflows over the past 29 months, Morningstar said.

Shelly Antoniewicz, senior economist at the Investment Company Institute, said though ICI figures show actively managed domestic stock funds with net outflows of about $60 billion this year through April, the domestic equity picture overall isn’t as bleak as it is sometimes made to appear. In fact, when U.S. equity index funds and ETFs are included, domestic equity flows, despite some recent weakness, “have been positive for quite some time.”

“You’re not getting the big picture if you [say investors are] shunning the domestic equity market,” she said, adding that dollar strength and concern over a potential Federal Reserve interest rate hike may be curbing investor demand.

Roof Advisory Group has “plenty of U.S. domestic equity exposure,” its president said.

“As opposed to painting things with a broad brush, we prefer to take a look at what funds we are utilizing or not, based upon more discrete factors,” Mr. Roof said. “And as a result, there’s probably not just one generalized category as in domestic equity that we are avoiding.”

Instead, Roof Advisory is looking to reduce exposure to funds and individual securities that would be negatively affected by a stronger dollar.

GOING FOR GROWTH

“What has happened is, overall large-cap value exposure for many of our portfolios has dropped a bit in favor more of the large-cap growth exposure,” Mr. Roof said, adding that the shift occurred in the first part of this year in particular.

Also, for the first time in many years, Roof Advisory has increased exposure to small-cap funds be-cause they tend to be less affected by dollar strength. Small-cap exposure now accounts for about 5% to 7% of Roof’s equity portfolio.

“It’s not like we’ve shifted from large cap to small cap entirely, it’s just we did not see the value in the small-cap space until I’d say maybe nine months ago,” he said.

Roof Advisory has shortened bond duration. Until the Federal Reserve acts and interest rates rise to a level that makes fixed-income investing more attractive, that will likely continue to mean a tail wind for the equity market, Mr. Roof said.

“Because short-term interest rates are so low, investing in [long-term] bonds in the current environment — especially with the specter of rising interest rates on the horizon — that’s a risky proposition,” he said “We’ve shortened our duration and have had it short for several years.”

According to Morningstar, intermediate-term bond funds netted $5.3 billion in May, ranking them in third place among top flowing fund caegories behind the foreign-large-blend and large-value categories. Of that $5.3 billion, $1.7 billion flowed into actively managed intermediate-term bond funds. Pasively managed intermediate-term bond funds netted $3.6 billion last month.

Though bonds and bond funds typically don’t do well in a rising interest rate environment, one explanation for intermediate-term bond funds’ appeal could be that investors like bonds’ lower volatility relative to stocks, Ms. Lamy said.

Investors likely prefer intermediates because they are less sensitive to interest rates than longer maturities, the analyst said. Investors’ preference for actively managed intermediate-term bond funds may reflect their faith in active managers’ ability to navigate future interest rate volatility, she said.

Mr. Brooks said while he can’t say for sure what’s driving the interest in intermediate-term bond funds, he does have a theory or two. One is that investors aren’t expecting interest rates to rise that quickly, in which case intermediate-term bonds should at least hang in there with short-term bonds.

“Those of us who have been parking money in short-term bonds awaiting the bond market apocalypse have been seriously underperforming intermediate-term benchmarks,” he said, adding that a rate hike is “not the kiss of death” for intermediate-term bonds.

“It does mean short-term underperformance, but you have to remember that a bad year in bonds is a bad day in the stock market, and I think advisers are starting to figure that out,” Mr. Brooks said.

Another possible help for intermediate bonds is investors’ expectation that the dollar will rise against other currencies. That attracts capital from around the world, much of which is looking for bonds, he said.

“Capital flowing into the bond market will put downward pressure on rates, even as the Fed raises short-term [rates],” Mr. Brooks said.