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Christine Benz:Hi, Im Christine Benz for . If youre a mutual fund investor, its a good bet that your funds ended the quarter in the black. Joining me to provide a recap of the first quarter in mutual funds is Russ Kinnel. He is director of manager research for Morningstar.
Benz:Russ, we are not quite done with the first quarter, but it has shaped up to be a tremendously good quarter for investors. Lets talk about why we saw this reversal of some of the problems that investors were having in the fourth quarter of 2018. What drove investors to be more sanguine?
Kinnel:We had all that angst in the fourth quarter. S&P lost about 13%. Now, first quarter, S&P is up about 13%, meaning we havent caught up all of our gains, but we are close. But it seems like all of those worries have really diminished a bit. We were talking about trade wars and Brexit and things like that, and of course, the trade wars have softened a little, but Brexit is still out there.
Kinnel:But it seems like common reversal. We see this all the time, where you kind of overdo it in one direction, and you come back and correct for that, and you are at the same place you were to start.
Benz:So, lets talk about some of the mutual fund categories that performed particularly well during the quarter. It was a strong quarter almost across the board, but there were some standout categories. Growth-oriented funds generally continued to beat value. Lets talk about that.
Kinnel:Small growth and mid-growth were the best places to be, some really strong gains there. Funds like Artisan Small Cap and Baron Small Cap had particularly strong returns. But really great double-digit returns across the board on the growth side.
Benz:And that carried over to international equities as well. Performance wasnt quite as strong as U.S. equities, but nonetheless, a stellar quarter for foreign-stock investors.
Kinnel:Thats right. It was more like 6% to 10% for foreign, but thats a really good quarter, too.
Kinnel:So, a really strong quarter across the board.
Benz:In terms of the worst-performing categories, Im guessing the conservative stuff didnt do as well as the more aggressively positioned equity funds. Lets talk about that, the categories that disappointed a little bit or maybe just didnt earn stellar gains.
Kinnel:There are categories that, as you say, always have modest returns: the short-term taxable-bond category, short-term muni, market neutral–they had somewhere around 50 basis points of returns, which is not bad for them.
Kinnel:But everything else did so well, they looked bad in this quarter anyway.
Benz:I think investors are maybe taking stock. It has been such a great quarter. What counsel would you offer them knowing that all investors are different? But we have been through a very long-running equity market rally. Can you share any guidance about how investors should approach their portfolios?
Kinnel:We have another lesson in how hard it is to time markets. I mean, who could have imagined you should sell before the fourth quarter started and then buy when the first quarter started. No one was predicting that. So, I think thats a constant lesson were always learning. Its always humbling when you try and predict markets. I think thats one thing. But I do think even as we have another rally, there are warning signs again. A lot of talk right now about how the yield curve has inverted. That means you are getting paid more yield on the shorter end than the longer end, which is weird–it doesnt make sense if you are committing to more time. But what it means often is that if you expect a recession, of course you think all the yields are going to come down and therefore, youd rather lock in that long-term yield
Kinnel: if its not particularly attractive. So, if that is really what its saying, and the yield-curve inversion is a pretty good predictor of recessions and bear markets, then theres a whole lot of reason to worry. Of course, now, as people are talking about it, some say, well, it has to stay inverted for a full quarter to matter. Others are saying, often you see a blowout rally and then a sell-off. So, I think there are mitigating circumstances, and I dont think anything is a sure thing to predict the markets. But certainly it ought to sober you up a little, even after weve had this nice rally.
Benz:If you are looking at your asset allocation and you are 10 years older than you were when this started, and we all are, maybe consider derisking your portfolio a little bit rather than putting more chips on the stuff that has performed really, really well.
Kinnel:Thats right. The fear of missing out and envy are among the worst reasons to invest. I think even simple rebalancing would imply you are selling some equities and moving into bonds. Theres certainly some warning signs out there. Brexit is still looking like a train wreck.
Kinnel:And so there are a lot of reasons to worry still. So, I dont think its a time to take more risk on. It was a great quarter for risky assets, but those things dont necessarily continue.
Benz:OK, Russ. Thank you so much for being here to provide a recap.
Benz:Thanks for watching. Im Christine Benz for m.
Christine Benz:Hi, Im Christine Benz for Morningstar.com. Bond-fund investors enjoyed a solid first quarter as worries about rate hikes eased. Joining me to provide a recap of the first quarter in bond mutual fund performance is Sarah Bush. She is Morningstars director of fixed-income strategies in Morningstars manager research group.
Benz:Sarah, lets talk about the first quarter. I noted that it did seem like investors kind of breathed a sigh of relief about further rate increases. Was that the main thing stoking strength in the bond market in the first quarter?
Bush:So, what was really interesting about the first quarter is that we saw strength in the high-yield market and credit markets at the same time that we saw a rate rally. So just kind of taking those two separately, the Fed was definitely a big part of that story. So, high-yield and credit markets, which had done bad in the fourth quarter of 2018, you start getting a little bit more of a dovish stance coming out of the Fed at the beginning of the year and you have the high-yield markets and credit markets really take off in the first couple of months. And then, with the news in March even more of a dovish stance coming out of the Fed with some skepticism about whether well see any rate hikes in the near future, then you really see the Treasury market take off and you saw a big rally in 10-year Treasury yields …
Bush:Long-term bonds. And thats kind of unusual because often you see those two markets, the credit risk markets and the long-term high-quality bond yields, they dont always move together.
Benz:So, it was almost like no matter where you went in bond-land, you did all right. Lets talk about some of the best-performing categories. You hinted at high-yield being a pocket of strength. Any other areas?
Bush:Absolutely. So, anything that was in that credit risk bucket, so convertibles, which sort of sit on the cusp of bonds and equities, did very well. High-yield bonds did very well. Emerging markets had a pretty good quarter. And then turning over, you saw long bonds do quite well because of that rally that we saw in the Treasury market, and a lot of that was kind of coming more in March than earlier in the period.
Benz:So, there werent really any truly bad spots. The shorter-term more-conservative funds didnt perform as well, but thats about what you would expect in kind of a risk-on environment, right?
Bush:Exactly. You do the sort of the categories for the quarter returns, and at the bottom you see ultrashort bond and short government, and they are still very much in positive territory. Nobody is losing money; they just didnt run up as much.
Benz:So, lets talk about what you are hearing, what you and the team are hearing. You talk to a lot of bond-fund managers. Its been a great quarter. Are there any areas where investors, where fund managers are feeling notably worried about the bond market given that we have had such a strong rally in some of these areas?
Bush:Absolutely. So, I think that there is not a huge amount of worry out there broadly. Some people use that Goldilocks term. If we have sort of steady growth for bonds, its good to have steady growth and low inflation and not a lot of concerns about rates. The one thing that you are hearing, and we certainly were hearing this last year as well is just we are getting very late in this credit cycle. You certainly then start paying attention to what are some of the areas of the market where there may have been a lot of issuance or maybe standards are getting lowered. So, people are paying attention to their high-yield allocations. Bank loans, the bank-loan market has really just exploded. Theres been a lot of news about the so-calledcovenant-lite issuance, which just means theres fewer restrictions on borrowers in that market. And so, thats a market that you hear some people with some skepticism about.
The other sort of theme on the credit side is weve seen a really big explosion of BBB issuance. So, those are still investment-grade, but they are kind of at the bottom of that investment-grade tiering. And theres been a lot of issuance there and weve seen leverage rates go up in that part of the market. So, the concern there is maybe less that a lot of those companies go bankrupt, but if they do get downgraded to below-investment-grade, so they just have to come down a little bit into B and that kind of junk-bond market, that could be a challenge. There are some investors who cant buy or hold below-investment-grade debt, and just all that debt coming into the junk-bond market could be a challenge.
Benz:And thats an issue for investors. Even if they dont hold a high-yield fund, that stuff can show up in your high-quality, say, intermediate-term bond fund, right?
Bush:Exactly. You might have some high-yield, but you could also, even in a pure high-quality fund where they are not holding junk bonds, you can see a lot of BBBs. And theres a lot of BBBs, say, in an index fund, which is the broad market type, Vanguard Total Bond Market Index. Those do have a big chunk of BBBs just because they become a bigger part of the overall market.
Benz:So, lets talk about something thats been very much top of mind for engaged investors: this idea of the yield-curve inversion. First, lets talk about what that is, and lets talk about why people have been so focused on it–they think that it could actually be a precursor to some sort of an economic weakening or a recession?
Bush:So, basically,yield curveis a fancy way of saying if you look at the yields on maturities going out from very, very short debt out to the 30-year bond, what does that look like? And in a normal environment, what you are going to see is that you get paid more yield as you go out into longer-maturity bonds. You know, theres uncertainty about whats going to happen with rates and investors demand more yield in most environments. What weve seen more recently is an inversion of parts of the curve where longer-term bonds are actually yielding a little bit less than some of the shorter-term bonds.
Bush:Demand is there, yes. So, its actually a little crooked but you do have that inversion where instead of seeing that upward slope as you go out, maturity is coming down a little bit. So, why that is of such interest is that the inversion of the yield curve has done a good job of predicting the past few recessions. So, then the question becomes: Is this a sign that we are not in a Goldilocks economy, we are actually moving towards something where people are worried about economic growth?
And I think what weve heard is mixed. First of all, although its been a very good signal, we have a relatively limited sample size and the economy has changed a lot over the last 50 years. So, thats one thing to consider. The other is that some people do argue that we are more in this Goldilocks economy–that things could keep going fairly well. Even when the yield curve has done a good job of predicting a recession, sometimes theres a lag, quite a significant lag, between when the yield curve inverts and when we get the recession. So, Im not hearing a lot of panic. As I mentioned earlier, you do have people thinking, OK, we are in the later stages of this economic expansion. So, you want to pay attention to what kind of risk you are taking. But in terms of people being worried that very quickly we are going to be moving into a recession, we are not hearing a lot of that from managers.
Benz:But from a practical standpoint, if Im a bond investor, there are implications in terms of the yields that I earn by being in short-term bonds. You and the team have looked at this–and I know Miriam Sjoblom, our colleague, has looked at that short-term category–and said at certain points in time, maybe right now, its an opportunity for short-term investors.
Bush:So, usually, the reason that you would hold longer-term bonds is because you are paid more yield to take–theres more interest-rate risk. And today, you are getting pretty good yield comparatively in short-term bonds. So, I think thats something that can present an opportunity. We certainly hear that from some managers. BlackRock, for example, is finding opportunity in income at the short end of the curve, and thats been an opportunity for them. So, I think thats something to think about for investors. You dont necessarily need to go out into a longer-term bond fund to get reasonably good yield opportunities.
The other thing, though, is–just to go back to the uncertainty about the yield curve–nobody is very good at predicting where these things are going. Even professional investors kind of struggle to tell you whats going to happen in the next six months, economists. So, it really is a situation where you should look at the risks in your portfolio, understand whats there, understand how you are likely to react if various parts of your portfolio underperform. But really, once you are comfortable with that, I dont think investors need to go out and be making big changes to their portfolio because of a signal like this.
Benz:Sarah, super helpful recap. Thank you so much for being here.
Benz:Thanks for watching. Im Christine Benz for Morningstar.com.
Christine Benz:Hi, Im Christine Benz from Morningstar.com. As the first quarter winds down, investors continue to barrel into very low-cost exchange-traded fund products. Joining me to provide a recap of the first quarter in ETFs is Ben Johnson. Hes Morningstars director of global ETF research. Ben, thank you so much for being here.
Christine Benz:Ben, lets just do a quick stage setting, talk about the market environment in the first quarter. In some ways, you say it was really just a reversal of what we saw in the fourth quarter of 2018, right?
Ben Johnson:Well, the entirety of 2018 really. If you look at calendar 2018, as far as investors were concerned, there was no place to run and no place to hide. Virtually everything went down last year. And what weve seen thus far in 2019 is a reversal of that trend–that virtually every Morningstar Category on a year-to-date basis has posted positive returns. And you see that manifest–sort of a return of investors risk appetite–in ETF flow data. So what weve seen is a return to healthy flows that have been roughly $50 billion on a year-to-date basis that have flowed into exchange-traded funds. And most of that, if you look through the lens of Morningstar Categories, has gone into the U.S. large-blend category, so that would capture things like S&P 500 ETFs, total stock market ETFs. Its gone into diversified emerging markets, and its gone into corporate bonds. So as you can see, as evidenced by these flows, investors have a bit more appetite for risk this year certainly than they did last year.
Christine Benz:And then within categories, investors continue to gravitate to very low cost, you call them vanilla, product types. Lets talk about that.
Ben Johnson:Absolutely. So if you were just to look through the lens of fees and isolation and flows into ETFs that charge a fee of 10 basis points, of 0.10%, or less, those have accounted for the majority of net new flows. Now these ETFs tend to be uniformly sort of dull, boring, uninteresting. Very vanilla, broadly diversified, market-capitalization-weighted, and charging razor-thin and ever razor-thinner, expense ratios with time. While the menu has continued to expand–its become really somewhat saturated–investors preferences–their selections from this menu–continue to channel into the largest, the most liquid, the lowest-cost funds that are on offer.
Christine Benz:And then in terms of providers, we are seeing most of the flows going to just two firms, iShares and Vanguard. Lets talk about that.
Ben Johnson:So over two thirds of net new flows on a year-to-date basis have gone to those two players. Actually, as of today, the two are neck and neck in terms of the flows race. I think Vanguard has collected maybe a hundred grand more in net new money than iShares has for the year to date, and as a result, Vanguards market share within ETFs has actually edged up a little bit. IShares has slipped, albeit just very marginally. And I think this is inextricably linked with the trend we just discussed which is the trend towards all things vanilla, broad-based, very inexpensive, very broadly diversified. And it just so happens that these two players–as well as others, if you include at the margin State Street, which has benefited from a flows perspective from the launch of their portfolio series of ETFs, as well as Schwab, which has continued to make an absolute run at the top five here and has amassed immense amount of money, largely owing to the fact that they have whats for all intents and purposes, an effectively, sort of captive distribution platform working with their brokerage platform–those four have really gotten kind of a stranglehold on this large core of the market, which is all things dirt cheap and vanilla.
Christine Benz:One thing that I know you and the team follow very closely have been these fee cuts that weve seen across providers. And one thing that you and the team have noted and I think maybe investors on the outside looking in probably havent been paying attention to this is that some of those fee cuts are driven by considerations for portfolios that are run internally. So lets talk about that, talk about how in some cases the fee cuts may in fact relate to needing to populate these portfolios with the lowest-cost products.
Ben Johnson:So many of the largest ETF sponsors have begun to pivot away from selling individual slices of the pie, so an ETF that offers exposure to U.S. large caps or to a diversified core bond index, you name it, and towards building models. So theyve created all of these raw ingredients, and I liken it to going into your local Chipotle–Ive got 20 stainless steel buckets in front of me, each with a different ingredient and I can go from one end of the line to another and come out with 78,000 different kinds of burritos based on how I combine those things. So, the sponsors are moving towards mass customization, meeting the needs of a diverse client base by doing all of these different configurations with those raw ingredients, the ETFs at the portfolio level. So I would argue that at the margin, what weve seen and whats been called thefee war, could be as much a defensive move as it is an offensive one. So naturally you would think that edging out your competitor by a basis point or two here or there with fees would be an attempt to gain market share and absolutely thats part of the story. But I would argue that from a defensive perspective, as more and more of these sponsors are using proprietary products to build proprietary models, they want to be cautious about creating the appearance of any potential conflicts of interest. So if Im going to have three like funds that are effectively identical, and Im going to come into the market with a fourth fund, say tracking the U.S. total stock market index, and Im going to use that fund in my own model portfolios, I reduce the risk of people raising their eyebrows about my using my own fund in my own models if I price it 1 basis point below the three incumbents than I would if I had priced it at parity. So I think theres an optics risk of sorts that many sponsors may be looking to hedge against as more and more of them use their proprietary funds and their proprietary model portfolios.
Christine Benz:Well, lets talk about these model portfolios. Whos using them? What are they intended for?
Ben Johnson:Theres a variety of different investor types that are using these portfolios. The main area of growth has been in the intermediary space. So as more and more advisors have gone from picking stocks and throwing in the towel on picking stocks, to picking funds and throwing in the towel on that, to building portfolios themselves and now increasingly throwing in the towel on that exercise, theyre saying, Just show me. Give me the model itself. I know my client, I know what fits for them. Lets line up this information so that I can pull a model directly off the shelf, from whatever platform I might be using. So you see evidence of this phenomenon in the wire houses, you see evidence [of] it in the RIA community, who might custody client assets with say a TD Ameritrade or a Schwab. These models are being delivered to a variety of different client types and a variety of different means across the investor spectrum.
Christine Benz:OK, Ben. Another busy quarter in ETFs. Thank you so much for being here to provide a recap.
Christine Benz:Thanks for watching. Im Christine Benz, from Morningstar.com.
Susan Dziubinski:Hi, Im Susan Dziubinski for Morningstar. Retirees using the Bucket system probably put a lot of thought in how they invest their long-term buckets, but the cash bucket, Bucket 1, may get less attention. Joining me to share some tips for getting the most out of bucket one is Christine Benz, our director of personal finance at Morningstar.
Dziubinski:Now, lets review why Bucket 1 is there in the first place.
Benz:Its really there to serve as your spending money in case your long-term assets, your bond and your stock assets, for whatever reason are not cooperating. So, maybe your bonds arent delivering the yield you are looking for, maybe your stocks are down, so its not a good time to sell any pieces of those to meet your living expenses, your cash is there to meet your ongoing living expenses.
Dziubinski:And you think its important for retirees who may not be using a Bucket system in retirement to have some cash on hand?
Benz:I do. And its really for the same reason that I recommend it for people who are using a Bucket approach. The idea is that your long-term portfolio may be volatile at various points in time. Oftentimes or sometimes your best course is just to leave those assets undisturbed. A couple of other reasons youd want to have at least some liquid assets in retirement would be, if you have just unanticipated expenses and those come up in retirement just as they did when you were working. And you would also want to think about whether youre an opportunistic investor. So, maybe you are someone who likes to put money to work in long-term investments when theyre down. In that case, you might want to have a little bit of extra cash sitting around as well.
Dziubinski:So, then investors who are using the Bucket system, how do they figure out how much cash they need in that first bucket?
Benz:I always say its wise to take a step back, think about your total spending needs in each year of retirement, and subtract out any of amount of those income needs that will be met through nonportfolio sources, so pension, Social Security, rental income perhaps. Any other certain sources of income that arent coming from your portfolio, subtract those out. The amount thats left over is that you will be needing your portfolio to supply each year. I usually say retirees who are using a Bucket strategy should think about holding one to two years worth of portfolio withdrawals in true cash instruments.
The reason I lean a little bit more toward two years versus just one would be a year like 2018 where it wasnt a great year for bonds. Intermediate-term bonds were pretty much flat, some were even a little bit down for the year. And toward the end of 2018, it wasnt a great year for stocks either. So, the idea of having two years worth of living expenses set aside in cash would be, well, even if 2019 isnt such a great year, you can still leave your long-term portfolio undisturbed.
Dziubinski:Now, once a retiree has figured out, OK, this is how much cash I should have in Bucket 1, how does he or she decide how to deploy that cash, what to invest it in?
Benz:Its a really great point right now, Susan, because I think a lot of us had gotten used to this period where all of our cash was dead money, nothing was yielding anything, so why even bother. Well, now, if you havent looked at it for a while, its a good time to take a look because yields have really popped up. And so, you want to bear in mind that for most people will have a little bit of patchwork of different cash vehicles. So, you might have some money in your checking account just to meet your liquid expenses, but you might be willing to lock up your money a little bit longer in, say, a CD where you have less liquidity, but you have the chance to earn a higher yield. So, its worth getting to know the different types of cash instruments.
Money market mutual funds right now and CDs tend to be the sources of the best yields on the market today. With money market mutual funds, you just need to bear in mind that they are not FDIC-insured, in contrast with a lot of bank-type accounts. So, bear in mind that potential risk factor, albeit very small. With CDs, bear in mind the liquidity constraints that come along with holding CDs. I often talk to retirees who build laddered CD portfolios and that can certainly be an effective strategy for wringing out more income from your cash securities. I think the key thing is to not be complacent and to not assume that youll not earn anything on your cash because if you shop around, you can.
Dziubinski:Now, what shouldnt you be putting in that Bucket 1? Why shouldnt you be considering cash and what are some of the risks to look out for?
Benz:One of the key things to keep in mind is if you are someone who uses our X-ray functionality within Portfolio Manager on Morningstar.com, you can see the cash allocation, but thats taking into account residual cash holdings that might be in your mutual funds, so you might have like a large-cap growth fund, for example, that has a 10% cash holding. Well, thats going to show up in your X-ray, but thats not your money really to say to the fund manager, I want just my cash back. Unfortunately, thats not how it works. So, bear in mind that you are looking at your true cash allocations when gauging how much you have in cash.
And then another point I would make is that sometimes I talk to investors who want to nudge out on the risk spectrum a little bit in an effort to capture a higher yield. Thats not really my vision of what bucket one should look like. My view would be to keep it very safe, very simple, invest in true cash instruments there and save even high-quality short-term bond funds for bucket two where you are willing to tolerate a little bit of volatility.
Dziubinski:Now, assuming a retiree has his or her Bucket system up and running, how do you go about maintaining it? What are the steps they take?
Benz:This is one thing that I think is really important to think through before you get started with a Bucket system. How are you refilling bucket one because you are spending from it on an ongoing basis? There are a few ways to go about it. One would be to rely largely on current income distributions, whether income from bonds that you hold or dividends from dividend-paying stocks. The risk is, as we saw in the wake of the financial crisis, there will be periods where yields secularly drop very, very low. So, thats a trade-off.
Another strategy would be to just use a pure total return strategy where you are reinvesting your income distributions back into the portfolio, then periodically taking a step back and reviewing are there appreciated portions in this portfolio that I could lighten up on, potentially reduce risk in this portfolio while also sending money over to bucket one because Ive been spending from it. Thats the pure total return strategy.
A strategy that Ive come to like more and more is kind of a hybrid of the two where you build a portfolio, but you are not stretching for income production. You are just building a well-diversified portfolio and you are sending income distributions as they occur into bucket one as you spend from it, but you are also maybe once annually taking a look at that portfolio and seeing whether theres some rebalancing that you might do to meet additional cash flow needs. So, that hybrid strategy, I think, can be appealing because psychologically you are getting some cash flows through the income distributions and so, you are not relying totally