Moody's upbeat on mutual-fund companies for the third quarter

Outflows at Franklin and Waddell & Reed mask overall healthy inflows

Aug 30, 2016 @ 12:56 pm

By John Waggoner

The third quarter could be upbeat for mutual fund companies, according to a new report from Moody's Investors Service, but those with high costs and poor performance won't fare as well.

On the plus side, low volatility after the Brexit vote in June, combined with relatively good stock market performance, augurs better asset flows to mutual funds in the third quarter.

"Investors don't like volatility,” said Neal Epstein, senior credit officer at Moody's. “We're seeing a very gradual recovery across all asset flows.”

And, in fact, net flows to traditional investment managers were better than they would seem from the aggregate. Traditional managers saw a $9 billion inflow in the second quarter, which isn't anything to write home about. But Franklin Resources and Waddell & Reed saw combined outflows of $30 billion.

“Excluding their negative contribution, combined net inflows to traditional managers were $39.0 billion, and long-term net inflows were $16.0 billion,” the report said.

Better economic stability is also a good portent for increased fund flows, which translates directly into higher revenues. Consumer spending increased 4.2% in the second quarter, the unemployment rate fell to 4.9%, and wages rose more than expected.

“As risk appetite returns, we would expect product inflows to build through Q3, with ETFs benefiting more from higher equity markets than mutual funds, which continue to be challenged by structural inefficiencies and an overall lack of confidence in active management,” the report said.

The funds can thank the Federal Reserve for one small favor: A reduction in the number of money-market mutual funds that are waiving their expenses to keep their share prices from falling below $1. While many money funds are shifting to government-only status because of new Securities and Exchange Commission rules, yields on prime money funds are rising.

“Banks are paying more on their money-market products, and on the prime side, waivers are dropping,” Mr. Epstein said.

While rising rates could hurt some fixed-income funds in the short term, the Fed's ability to raise rates also serves as a confirmation that the economy has gone a long way in its recovery from the 2007-2009 financial crisis, Mr. Epstein said. And, while economic growth remains tepid, Moody's expects it to be at “the upper end of a low growth expectation – 1.5% a year or so.”

Mutual funds that include their distribution costs in their expense ratio — that is, most broker-sold funds — are likely to have a harder time getting new sales, particularly if their performance is lagging. Case in point: Franklin Templeton, whose funds are by sold brokers, saw $20.2 billion in net outflows in the second quarter, according to Moody's.

But advisers can take a lesson from Franklin, which puts tremendous emphasis on shareholder communications. “When performance has sagged, as it did in its global bond funds, sales dropped off but redemptions didn't increase,” said Mr. Epstein, pointing out that the company was able to communicate its strategies to shareholders and, as a result, investors were patient.

“They have a lot of loyalty, and if Franklin turns performance around, they should reignite sales,” he said.

Performance issues also continue to pressure Waddell & Reed, the report noted: The company saw net outflows increase to $9.8 billion in the second quarter of this year, up from $6.3 billion in the first quarter, driven by large institutional redemptions. Altogether, the company's Institutional channel contributed $5.5 billion to net outflows.

“Our outlook on Waddell & Reed continues to be negative given the performance of the company's flagship funds, persistent industry headwinds related to active management and our expectation that the Department of Labor fiduciary rule will have a significant impact on the company's Advisors channel,” the report said.

On the whole, earnings before interest, taxes and depreciation (EBITDA) rose 1.42% for traditional managers, Moody's says. This isn't to say that the long-term problems besetting the industry have gone away. Active managers are still lagging their passive counterparts, at least in terms of gathering assets. But even some passive managers saw their inflows slow in the second quarter as volatility spiked.

“BlackRock flows came to a grinding halt,” Mr. Epstein said. Inflows into iShares were $10 billion in the second quarter, down from $17.5 billion the previous quarter.

“Nonetheless, the company's iShares franchise continues to benefit from the growing use of passive management, particularly in fixed income,” the report noted.

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