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First quarter sees a rotation towards US and Japan as EM and Europe equity funds stumble

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The opening three months of 2013 ended with EPFR Global-tracked equity funds having posted a bigger quarterly inflow than bond funds for the first time since Q3 2007, confirming – at first glance – the popular narrative of a “great rotation” from equities to bonds driven by rising investor risk appetite.

 
On closer examination, fund flows during the first quarter did not tell such a neat story.
While investors showed a much greater appetite for equity, their commitments to dividend equity funds have accelerated and they have also shown a strong preference for the perceived safety of US equities or funds that offer exposure to both equities and fixed income. The cash they put to work came from money market funds rather than bond funds, which have taken in a healthy USD85bn year-to-date, and investor commitments to global sector funds have favoured the more defensive groups.
 
Among the drivers shaping flows going into 2Q13 are Japan’s aggressive monetary and fiscal policies, the impact of Italy’s inconclusive elections and the messy Cyprus bank bailout on the Eurozone’s immediate future, rising inflation in key emerging markets and the reformist zeal – or lack of it – China’s new leadership will display in the coming months. Investors have already responded to some degree, with fund flows in March pivoting away from funds offering exposure to emerging markets and Europe, and towards US and Japan Equity Funds. 
 
Although the year still has nine months to run some fund groups are already on course for – or even in – record setting territory. These, based on combined monthly and daily data through the end of March, include Mexico equity, Japan equity, healthcare/biotechnology and consumer goods sector.  
 
After a storming start to the year, flows into EPFR Global-tracked emerging markets equity funds faltered during the final weeks of 1Q13 as investors shifted their attention – and money – from funds offering exposure to European and emerging markets to those focusing on the US and Japan. Emerging equity funds, which pulled in USD32.5bn during the first two months of 2013, have seen over USD2bn redeemed since the beginning of March.
 
EMEA equity funds faced the biggest headwinds during the quarter. The Eurozone’s problems, fears that Russia’s consumption story has run its course, inflationary pressures there and in South Africa,  softer commodity prices and the ongoing political turmoil in the Middle East and parts of Africa have all taken a toll on investor sentiment and this fund group carried an eight week outflow streak into the second quarter.
 
Inflation is also an issue for investors looking at Latin America. Concern that Brazil’s monetary policy has been too accommodative, given that country’s history with hyper-inflation, was among the factors that drove flows away from Brazil equity funds and into Mexico equity funds during the first 13 weeks of 2013. 
 
Flows into Asia ex-Japan equity funds were driven by optimism about China during the first eight weeks of the year. But fears the new leadership will move aggressively to curb excesses in the banking and property sectors, even at the cost of some growth, prompted investors to pull back in March and focus their attention on some of the smaller regional markets. Both Thailand and Philippines equity funds recorded their biggest quarterly inflows since EPFR Global started tracking them in 1996.
 
 
Once again the BRICs (Brazil, Russia, India and China) theme stood out among the main emerging markets fund groups for the wrong reasons. Dedicated BRIC equity funds have now posted outflows 107 of the 119 weeks since the beginning of 2011. The other EM themes, however, fared well.
 
EPFR Global-tracked developed markets equity funds ended March having enjoyed their best quarter on record as money poured into US, Japan and the diversified global equity funds. Retail investors, who have been conspicuous in their absence since mid-2Q11, committed fresh money eight of the quarter’s 13 weeks as they bought into America’s modest but steady recovery and the hope ‘Abenomics’ will jump-start Japan’s economy.
 
Although they ended the quarter hanging onto YTD inflows, the tide turned against Europe equity funds in late February following Italy’s inconclusive election – negotiations to form a new government were still going on a month later – and accelerated after the Cyprus bank bailout sage. At the country level flows into Italy equity funds proved surprisingly durable while flows into fund groups focusing on Nordic nations soared in February.
 
Also enjoying strong flows were Japan equity funds. Although some of that was due to a significant increase in the universe of Japan funds covered by EPFR Global, investors responded to the expansionary fiscal and monetary policies being championed by Japanese Prime Minister Shinzo Abe’s administration and new Bank of Japan Governor Haruhiko Kuroda. YTD US-domiciled funds have accounted for 57 per cent of the flows into all Japan equity funds versus 26 per cent for Europe domiciled and 16 per cent for Japan domiciled. Last year Japan domiciled funds accounted for all the net inflows.
 
US equity funds had a good quarter, with key equities indexes making runs at their record highs and flows accelerating in March as investors looked for alternatives to Europe. Small cap funds saw the biggest inflows, followed by mid cap funds with large cap funds the least popular. Actively managed funds enjoyed their best period, in flow terms, since 1Q11.
 
Flows into the major diversified developed markets fund group, global equity funds, consistently exceeded the USD1 bn mark as they took in fresh money every week of the quarter. Global and global ex-US equity funds took in roughly equal amounts during this period.
 
Despite the talk of rising risk appetite, several of the EPFR Global-tracked sector fund groups with defensive reputations stood out during a quarter when investors opted for bricks and mortar over gold and most precious metals. YTD real estate sector funds have attracted the biggest inflows while commodities sector funds, which recorded the biggest annual inflows every year from 2009 to 2012, are the outflow leaders thanks to heavy redemptions from gold and precious metals funds.
 
Both healthcare/biotechnology and consumer goods sector funds have retained the momentum they carried into the year. Flows into the former have been particularly strong, due in part to recent mergers and acquisitions activity and to expectations that US firms will see revenues grow as more of the US healthcare reforms come into effect.
 
Although taking a back seat this time to equity funds, flows into EPFR Global-tracked bond funds during the first quarter of 2013 continued at a pace that, if maintained, would see them take in over USD300bn for the year. Both emerging market bond funds and global bond funds are ahead of where they were during the comparable period last year and floating rate (loan) funds have already eclipsed their full year total for 2012, as have balanced funds.
 
Investors have pulled back from some of last year’s favourites, including high yield, municipal and mortgage backed bond funds, and have actively moved out of Europe bond funds. US bond funds have seen a marked shift to sub-groups tied to the short end of the yield curve while flows into EM bond funds have rotated from those with hard currency mandates to their local currency counterparts.
 
Overall flows into emerging markets bond funds have followed a very predictable pattern so far this year. During most weeks funds with local currency mandate outgained their hard currency counterparts, funds with an emerging Asia focus took in more than their Latin America and EMEA peers, and China bond funds posted the biggest inflows of any country fund group.

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