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Investors' love affair with mutual funds, ETFs will continue in 2014

Jin Lee | Boomberg | Getty Images

The 2013 trend was positive for net flows for both mutual funds and exchange traded funds. For U.S.-registered products, $163.6 billion of positive net flows went into mutual funds, while $141.2 billion moved into ETFs. The 2013 totals were aided by net inflows into equities, with $194.4 billion moving into mutual funds and $137.6 billion into ETFs.

Mutual fund and ETF flows to the short end of the curve are likely to remain positive but volatile in 2014 as investors await more clarity around the Fed's evolving bond-purchase program amid mixed economic signals.

Taxable fixed-income fund sector flows were positive at $20.7 billion, largely because of a strong first quarter. Taxable-fund net flows were actually negative during each of the final three quarters of 2013, reflecting investors' concerns surrounding the Federal Reserve's bond-purchasing program.

The municipal bond funds sector finished the year with record net outflows of $64.2 billion, which was a stark reversal from 2012's positive net flows of $46.0 billion, as investors focused on more fiscally challenged municipalities.The net-outflows trend appears likely to abate as municipal yields become more attractive and funds stress security selection. Money market funds had modest net inflows of $16.4 billion for 2013.

Within equities, the U.S. diversified equity funds segment (excluding ETFs) saw positive net flows ($61.7 billion) in 2013. These funds were aided by the continued demand for long/short products ($19.7 billion), the attractive yields within the equity income group ($21.0 billion) and demand for both multicap ($29.1 billion) and midcap core ($9.9 billion) funds.

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The net-inflows trend for these segments should persist. Alternative products remain popular choices due to their increasing accessibility as more new funds are launched and their perceived diversification benefits.The relatively low-interest-rate environment should continue to spur demand for equity income funds from yield-hungry investors.

The products with the greatest fund inflows in the mid- and multicap sectors are passive ones, such as Vanguard Total Stock Market Index Fund.These low-expense diversified funds should continue to bolster flows into these classifications, aided by their recent strong absolute returns and proven investment strategies.

Net outflows continued in the growth sectors: large-cap growth (-$20.2 billion), multicap growth (-$13.6 billion) and midcap growth (-$2.0 billion). However, their flows may stabilize in 2014. Larger funds in these categories, such as Fidelity Contrafund and American Funds Growth Fund of America, are actively managed funds that posted strong absolute returns and decent relative returns in 2013, while their five-year-performance track records now boast more attractive returns.

Sector equity fund net flows were helped in 2013 by the inflows to health care/biotech ($6.5 billion), natural resources ($6.1 billion), real estate ($3.4 billion) and specialty ($3.3 billion) funds. Net flows are likely to remain positive for health-care funds as demographic trends and structural reforms continue, while the demand for higher yields helps real estate fund flows.

The natural resources fund group has many domestic energy-focused funds that are benefiting greatly from the shale energy boom. This momentum should help to bolster flows into 2014.

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Specialty funds that are focused on infrastructure—an area that has capital expenditure tailwinds—should continue to see positive net inflows.

Commodities general (-$4.4 billion), global natural resources (-$3.9 billion) and precious metals equity (-$2.2 billion) funds had net outflows in 2013, as those segments were hurt by falling global commodity prices and weaker demand for raw materials. In addition, the selloff in gold and the expanding supply of domestic energy affected fund flows. Flows to the commodity sector may stabilize later in 2014 on better signs of a global recovery.

As 2013 progressed, the largest equity ETFs saw an acceleration of net inflows as investors became more comfortable with the stock market rally. The larger-cap State Street S&P 500 (SPY) witnessed net inflows of $13.1 billion during the fourth quarter, with a total of $9.8 billion for the year. iShares MSCI EAFE ETF (EFA) and PowerShares QQQ, which tracks the NASDAQ 100, also attracted net inflows on strong returns.

Future net inflows to all three ETFs—SPY, EFA and QQQ—will be heavily dependent on the staying power of the equity rally. They will become even more data-sensitive in early 2014 as investors seek signals that the underlying economic fundamentals are in place to sustain future gains.

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Emerging markets ETFs had a volatile flow ride in 2013 due to Fed uncertainty and depressed global commodity prices. SPDR Gold witnessed net outflows of $24.9 billion in 2013 as the price of the metal slid. The outflows trend for the product is likely to continue as the asset class remains out of favor with institutional investors.

The dominant theme for flows into taxable fixed-income funds for 2013 was short-duration. The least interest-rate-sensitive categories—loan participation ($57.4 billion net), short investment-grade debt ($20.4 billion) and ultrashort obligation debt ($9.4 billion) funds—were among the top classifications for net inflows. Both the ultrashort obligation ETF and the short investment-grade debt ETF categories had record net inflows in 2013.

As stated earlier, ETF and mutual fund flows to the short end of the curve are likely to remain positive but volatile in 2014 as investors await more clarity around the Fed's evolving bond-purchase program amid mixed economic signals.

(Read more: What other economic indicators tell us)

Longer-duration products such as core bond (-$53.6 billion) suffered net outflows. Additionally, as inflation expectations remained low, inflation-protected securities funds also witnessed net outflows. The negative-flow trend for longer-duration products and inflation-protected securities appear poised to continue into 2014, albeit at a slower pace.

—By Barry Fennell, Special to CNBC.com. Barry Fennell is a senior research analyst at Lipper, specializing in mutual fund research and performance analysis.

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