Beyond the Cycle of Outflows and Gains: 3 Funds for 2015

In our previous article we discussed how the relationship between fund flow and performance is gaining prominence. In many cases, outperformers tend to attract inflows. However, the strong rally may have run its course, leading to tepid performances by funds with high inflows. On the other hand, funds with low inflows or high outflows may be potential gainers in the future, as these seek to overturn their underperformance. (Read: How Do Fund Flows Affect Fund Performance? )

Every now and then, funds are off investors' radar for a reason, though there are some hidden gems that could be worth unearthing. In fact, data reveals outflows in a year have been followed by strong gains in the next.

This year, funds, active funds in particular, continue to bleed. According to Morningstar data, open-end mutual funds saw outflows of $31.9 billion in August. For the month, diversified domestic-stock funds witnessed outflows of $9.2 billion, taking the year-to-date outflows to $69.7 billion.

Then again, as already pointed out, outflows in a year may be followed by strong broader markets gains in the next year. Remember, in many cases the cycle is more reminiscent of arts than science.

Currently, the global economic outlook is rather discouraging. It is not clear if the trend of robust gains in the succeeding year of net outflows will continue. However, certain corners of the economy are still shining and sectoral funds may put up decent performances at least in the coming months. Before picking them, let's look at the funds' flow data for certain categories and their returns.

Fund Outflow Continues

The outflows in August came when every diversified domestic-equity Morningstar Category lost at least 4%. Taxable-bond funds suffered their biggest outflow since Aug 2013, but the selling pressure was not too intense. On the active side, they witnessed estimated net outflows of $19,511 million in August and $70,776 million for the 1-year period.

Close on the heels of Taxable-bond funds, US Equity funds saw outflows of $14,012 million in August on the active side. The 1-year outflow for US Equity funds touched $152,437 million. International Equity funds also witnessed outflows of $2,140 million in August, but on a 1-year basis it saw inflows of $41,414 million. International Equity funds saw inflows of $7,136 million for August on the passive side. The only other category to see outflows for both August and the 1-year period on the active side was Commodities funds. They lost $79 million in August and $1,554 over the 1-year period.

Alternative funds were the only exception as they attracted funds. On the active side, they saw inflow of $1,504 million in August, and $4,979 million in a 1-year basis. Morningstar noted that assets under management for these funds increased to $311 billion at the end of 2014 from $46 billion in 2008.

Read: Alternative Funds: Cause for Concern?

Market Rally Follows Outflows?

Interestingly, data shows that the S&P 500 has jumped every year following a year of outflow in US Equity funds. Data compiled since 1999 shows that inflows in 1999, 2000 and 2001 were followed by negative returns for the S&P 500 in the following years. This was also the case in 2007, when an outflow of $22.9 billion in US Equity was followed by 37% loss in 2008. However, that was also the year when the economy slipped into a recession. From 2008 to 2012, US Equity funds saw massive outflows, but the S&P 500 stuck to gains every succeeding year.

However, the trend is different in certain cases for the International Equity funds. Similar to the US Equity funds, inflows in 1999 and 2000 were followed by losses for MSCI EAFE in the following years. However, the trend reversed in 2001 when outflow was followed by another year of loss. The trend was only similar in 2008 when outflows followed a year of robust gains.

Separately, robust inflows for International Equity Funds in some cases were followed by losses in the next year. This happened in 2007, 2010 and 2013. Benchmarks are also in the red this year, after witnessing inflows in 2014.

Year US Equity Funds International Equity Funds
Fund Flow ($ in billion) S&P 500 Return in Following Year (%) Fund Flow ($ in billion) MSCI EAFE Return in Following Year (%)
1999 150.8 -9.1 10.4 -14.2
2000 213 -11.9 43 -21.4
2001 96 -22.1 -15.2 -15.9
2007 22.9 -37 177.7 -43.4
2008 -23.5 26.5 -50.9 31.8
2009 -52.3 15.1 59.3 7.8
2010 -41 2.1 87.4 -12.1
2011 -53.1 16 16.2 17.3
2012 -57.4 32.4 55.8 22.8
2013 149.9 13.7 201.5 -4.9
2014 82 -6.2 143.6 -5.6

Source: Morningstar

Will The Trend Continue?

There's more rhyme than reason behind this cycle of outflows followed by gains for the US equity funds. Economic events or developments that guide market movements do not depend much on the extent or nature of flows. Instead, flows may be a result of economic events.

On that note, it is not right to predict if outflows this year will lead to a robust 2016. The year 2016 may be a profitable one on other aspects; hopefully with subdued global growth worries. Right now, global growth fears have kept the bearish mood alive. Nonetheless, investors do have opportunities to reap profits this year. But for that to happen, it would be prudent to identify the winning sectors.

3 Funds to Profit from This Year

As we inch closer to the final three months of the year, the focus will shift to the holiday season. This will put the retail sector in the limelight. Holiday season is the time when retailers are on their toes, flooding the markets with offers and promotions. A gradual recovery in the housing market and manufacturing sector, along with an improving labor market and lower gasoline prices are playing key roles in raising buyers' confidence.

Moreover, the hullaballoo on the timing of the Fed rate hike was recently put to rest after the policy makers decided against a September lift-off. However, while nine out of 10 policy makers voted in favor of keeping the rate at the near zero level; 13 out of 17 committee members indicated that a rate hike may be possible this year. The chance of a rate hike in December was further fueled by Federal Reserve President Dennis Lockhart's hawkish comments.

Lockhart said: "As things settle down, I will be ready for the first policy move on the path to a more normal interest-rate environment. I am confident the much-used phrase 'later this year' is still operative." The finance sector, in this regard, seems to be a good bet, as several industries including insurance, banking, brokerage and asset managers tend to benefit from the rising rates.

Retail Funds:

Fidelity Select Retailing Portfolio (FSRPX) seeks growth of capital. FSRPX invests a large chunk of its assets in securities of retailing companies that are traded within the domestic boundary. These firms are involved in merchandising finished goods and services to consumers.

FSRPX currently carries a Zacks Mutual Fund Rank #2 (Buy). FSRPX has year-to-date return of 11.7% and has returned over 25.7% over the past 1 year. The 3- and 5-year annualized gains are 21.3% and 21.6%, respectively. The annual expense ratio of 0.81% is lower than category average of 1.46%.

Rydex Retailing Investor (RYRIX) seeks growth of capital. RYRIX invests almost all its assets in equities of US-traded retail companies. Apart from investing in small to mid-cap retailing companies, RYRIX may also buy ADRs to get exposure to foreign retailers. RYRIX may also invest in derivatives and US government securities.

RYRIX currently carries a Zacks Mutual Fund Rank #2. RYRIX has returned over 11% over the past 1-year period. The 3- and 5-year annualized gains are respectively 13.2% and 16.6%. The annual expense ratio of 1.33% is lower than category average of 1.46%.

Finance Fund:

Emerald Banking and Finance A (HSSAX) seeks long-term growth through capital appreciation. Income is a secondary objective. HSSAX generally invests at least 80% of its net assets in common stocks. Emerald Banking and Finance's managers limit fund investment to 50 companies and primarily in US-based companies.

HSSAX currently carries a Zacks Mutual Fund Rank #2. HSSAX has year-to-date and 1-year returns of 10.5% and 18.6%, respectively. The 3- and 5-year annualized returns are a respective 19.7% and 18.3%. Annual expense ratio of 1.60% is however higher than the category average of 1.52%.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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