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Why billions are pouring into blockbuster funds

In recent years the asset management industry has witnessed the rise of mutual funds and ETFs that dominate sales for their category. The key factors that create a blockbuster are brand, category demand, distribution prowess and investment performance.

Demand is also being driven by subtle trends in distribution. Most mutual funds are bought by intermediaries, such as advisors, 401(k) plans, insurance companies, etc. So it is important to monitor changes within the asset management industry that are leading to blockbuster products.

For example, most brokerage firms and other large wealth managers have been winnowing their recommended lists and model portfolios and are focusing resources on a few best-of-breed managers in each category. As intermediaries consolidate their lists, big funds get bigger.

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Jules Frazier | Digital Vision | Getty Images

Another reason for blockbusters is simple human behavior (I could say behavioral finance, but that's pretentious). It is not easy for investors to process the flood of new products and categories, so many investors simply choose funds based on performance. This causes assets to flow into funds with strong track records and top rankings.

Is this a smart decision, or is it just performance chasing? It is not easy to know. And when an investor is not sure what to buy, the quickest, safest decision is to just go with the crowd and buy the biggest product in the category. This type of herd behavior reinforces the blockbuster trend.

It is not always a bad thing to follow the crowd, since some blockbusters reflect long-term trends that are in the best interests of investors. Many observers would say that about the rise of passive funds.

Long-term appeal of passive funds

Passive funds dominated the rankings of top ETFs and mutual funds over the last 12 months, as shown in the accompanying charts. These are based on Lipper's estimated net flows over the last 12 months ending on Feb. 28, 2014.

All of the top-selling ETFs were passive funds, and five of the top 10 mutual funds were as well. The dominance of passive funds has deep roots that are worth exploring, since it suggests this trend will continue.

Passive funds have been gaining market share for years because they offer lower costs, higher transparency and greater tax efficiency. Passive investing has gotten a boost from the rise of fee-based fiduciaries, such as RIAs, and from ERISA's emphasis on low costs and broad diversification. In fact, usage of passive funds in 401(k) plans has helped familiarize investors with passive funds, reinforcing the emphasis on costs — especially for large, efficient asset classes. Consequently, Lipper has found that passive approaches have made the greatest inroads in the following fund macro groups:

—large-cap funds
—multi-cap funds
—U.S. diversified equity funds
—developed international markets funds
—long-term taxable bond funds
—mixed-asset funds

Read MoreTop trends in mutual fund investing

Top Ten Mutual Funds Ranked by Net Flows (Last 12 Months)

Name
Ticker
Assets (Mil) USD
Net Flows
Vanguard Total Stock Market Index Fund;Inst VITSX $70,273 $14,071
Vanguard Total International Bond Index Fund;Inv VTIBX $13,031 $12,840
Oakmark International Fund;I OAKIX $30,159 $12,390
Goldman Sachs Strategic Income Fund;Inst GSZIX $13,183 $10,810
Vanguard Total International Stock Index Fund;Inst VTPSX $27,198 $9,089
JPMorgan Strategic Income Opportunities Fund;Sel JSOSX $18,228 $7,361
Vanguard Institutional Index Fund;Inst Plus VIIIX $75,781 $6,819
Vanguard Total Bond Market II Index Fund;Inst VTBNX $26,607 $6,331
Bridge Builder Bond Fund BBTBX $6,306 $6,245
Fidelity Strategic Advisers International Fund FILFX $22,795 $6,094
Source: Lipper, A Thomson Reuters Company

Passive funds have propelled Vanguard to the top of the rankings: Five of the top 10 mutual funds and two of the top 10 ETFs in the past 12 months were Vanguard funds, when ranked by net sales. Vanguard has benefited from the shift toward low-cost passive investing, and it has been a consistently strong asset gatherer. The rankings of passive asset managers like Vanguard tend to be relatively stable, since sales are dominated by core asset classes, such as stocks and bonds, and these do not go out of style.

Economies of scale count for a lot in passive funds, since this helps keep costs low. Vanguard and other passive managers have used scale as competitive edge by cutting prices and reinvesting in wholesalers, marketing material, investment tools and content that serves as thought leadership. These efforts help increase their competitive advantage and help their products become entrenched best sellers. If we compare blockbuster funds to blockbuster movies, the Vanguard franchise has reliable box-office mojo.

Global Blockbusters

Another powerful secular trend is globalization. This is driven by a desire for the high growth and diversification benefits of international markets. Within mutual funds, two beneficiaries of globalization are Oakmark International Fund (OAKIX), with $12.4 billion in net sales, and Fidelity Strategic Advisors International Fund (FILFX), with $6.1 billion of net sales. Globalization was quite evident in ETFs: The top five ETFs over the last year focused on Europe, Japan and international stocks. These five ETFs, plus one more global ETF in the top 10, posted total net sales of $38.5 billion.

Beyond Bonds

Top Ten ETFs Ranked by Net Flows (Last 12 Months)

Name
Ticker
Assets (Mil) USD
Net Flows
Vanguard FTSE Europe ETF VGK $15,752 $7,543
iShares MSCI Japan ETF EWJ $13,968 $6,886
WisdomTree Japan Hedged Equity Fund DXJ $12,084 $6,602
iShares MSCI EMU ETF EZU $10,128 $6,333
Vanguard FTSE Developed Markets ETF VEA $20,635 $5,830
Vanguard Total Stock Market Index Fund;ETF VTI $41,098 $5,402
iShares MSCI EAFE ETF EFA $54,576 $5,265
Vanguard 500 Index Fund;ETF VOO $16,111 $5,105
PowerShares Senior Loan Portfolio BKLN $7,008 $4,384
iShares 1-3 Year Treasury Bond ETF SHY $11,821 $4,370
Source: Lipper, A Thomson Reuters Company

Finally, investors are looking "beyond bonds" for income these days, and this drove sales of three of the top 10 mutual funds. This includes funds from Goldman, JPMorgan, and Bridge Builder from regional broker-dealer Edward Jones. If we include floating-rate notes as part of this trend, it would also include one ETF, the PowerShares Senior Loan Portfolio (BKLN). All told, these four products had net sales of $28.8 billion over the last 12 months.

Demand for these blockbusters is based on deep concerns about future inflation and interest-rate policy. After a 30-year bull market in bonds, U.S. investors are now focusing on how fast the Federal Reserve will taper its bond purchases and begin the process of normalizing interest rates. Concerns about rising rates have been driving large shifts in investor demand — away from government and municipal bonds and into other fixed-income products, such as corporate bond funds, loan participation funds and world taxable fixed-income funds.

Rate concerns are also behind the blockbuster products that go beyond bonds and seek enhanced income with fewer constraints on the portfolio manager. The names of these mutual funds hint at greater freedom for the portfolio manager: Goldman Sachs Strategic Income (GSZIX) and JPMorgan Strategic Income Opportunities Fund (JSOSX). The popularity of these mutual funds shows that investors are less concerned with style boxes and more concerned with finding new fixed-income solutions.

Read MoreAre ETFs the Amazon.com of funds?

In Lipper's report on product innovation, we discuss these new fixed-income solutions that fund providers are using to meet investor needs. These approaches vary in how much emphasis they put on the different roles of bonds: income, diversification and liquidity. Lipper believes that demand will remain robust for new approaches to fixed income as retirees seek lifetime income. Lifetime income is especially difficult to achieve when interest rates are low and longevity is rising.

This drives demand for new bundled solutions as well, such as the Bridge Builder Bond Fund (BBTBX) from Edward Jones, mentioned above. This proprietary fund is built for fee-based advisors at Edward Jones, which is using an affiliated company, Olive Street Investment Advisors, as a sub-advisor. So this blockbuster fund shows how distribution prowess and a hot category can lead to a blockbuster product.

What do these trends mean? Investors and advisors should not buy a fund merely because it is a blockbuster. Most of these funds have strong track records, and all of the portfolio managers sound smart. But everyone sounds smart when the strategy is making money, and advisors should not merely follow the herd and pile into a hot fund. Be wary if an advisor is speaking only in vague generalities and not describing anything that distinguishes the fund from its peers—that's a clear tip-off.

Here are some simple investment strategies:

1. Passive funds: As an advisor, I often use ETFs and index funds for large, efficient asset classes (such as large-cap U.S. stocks). The best passive funds have a combination of low costs and low tracking error.

2. Global funds: Investing globally is a lot easier said than done, and it makes sense to start with a diversified basket like the VTIBX. The recent flood of money into Japanese equities (EWJ and DXJ) is a targeted bet that is suitable for traders or as a satellite holding.

3. Beyond Bonds: Investors hate low interest rates, and they hate complexity, so they want bundled solutions for lifetime income. In this case, a good advisor may be a better option than a mutual fund: Advisors can customize and create a retirement portfolio with low costs and high transparency.

Robert J. Martorana is a CFA and portfolio manager of Right Blend Investing. He publishes research on the mutual fund and ETF industries for various consulting firms. Follow him on Twitter @RobertMartorana.

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