In a nutshell, I want to own securities held by asset classes receiving large inflows of cash over an intermediate 6 to 12 month time scale, and avoid asset classes facing large intermediate-to-long term outflows.
Large intermediate-term inflows create essentially continuous daily net-demand that tends to bid up the price of the associated securities over time. Outflows do the opposite. We want to jump ahead of the buying and selling as long as the flows are significant and expected to continue over time. Inflows leading to outperformance can also be self-reinforcing as many investors are susceptible to performance chasing (flows lead to more flows).
Who’s on the other side of this trade? Long-term flows tend to be strategic allocation decisions made by large institutional investors, foreign investors, investment advisors/brokers and retail investors, in a manner that is typically price-insensitive. Nowadays the vast majority of investors spend their time deciding what investment manager to hire rather than what securities to purchase. When fund managers receive new money, they tend to buy what they already own. Not all funds do this, but most do, and index funds in particular must buy securities in exact proportion to the current portfolio.
While there are many excellent and talented investors in all the above groups, allocation decisions tend to be herd-like and heavily correlated with each other. These allocation waves can last for years as hundreds of institutional investors, millions of advisors/brokers and tens of millions of retail investors implement the latest fashionable portfolio allocation approach. The faster an asset class trader can jump on these trends, the more profitable this edge may become.
On the short time scale, daily flows are very difficult to predict and generally coincide with price action. These flows tend to be associated with fellow traders, hedge fund managers and also emotionally driven investors reacting to news. This blog is not about gaming short-term flows.
Furthermore, intermediate-long term flows cannot be used to predict when a bear market or correction may occur. For instance, there were huge retail inflows into technology, Internet, and large-cap growth stock funds in the late 1990s, yet the short 1998 equity bear market also occurred during this time period.
This sort of investment flow analysis is great for providing an edge in predicting the relative performance of one asset class versus another over the intermediate term. When flows are supportive, we can expect price and relative performance trends to be stronger and longer lasting.
Issues and Counterarguments
There are a couple issues with my view that intermediate-term flows represents an asset class trading edge. The first issue is that flows shouldn’t matter, because for every buyer there’s a seller. This view is way too simplified, as I’ll explain.
Each moment, market prices are determined by supply and demand, with prices set to balance buy and sell orders. This is the market clearing price. Prices don’t have to move on new “fundamental” information only. A sudden change in demand (or supply) can significantly move prices even if each trade during the price-move matched a buyer and a seller.
Inflows can be viewed as additional demand that comes to the market each day. It’s price-insensitive buying, thus it doesn’t matter if the price has risen over the past week, month, or three months; the buying appears day after day. Market makers are taking the other side of these trades and they set prices higher when excess demand hits the market.
Over an intermediate-term trend, market makers seek to remain market-neutral, so there has to be other sellers as prices rise. Certainly, if prices rise enough, then value managers begin to sell, rebalancing trades occur, and companies begin issuing more securities (supply increases). In addition, various hedge funds and mutual fund managers in this space tend to sell as prices rise, perhaps because their analysis suggests that prices have gone too far too fast, valuations are stretched, or because they’ve missed the big picture with respect to asset allocation flows.
A second issue is that investment flows are reasonably well known and predictable. So shouldn’t the effect be arbitraged away? I’ve wrestled with this question for years, but I’m comfortable with the view that if the flows are large, and are produced by price-insensitive asset allocation decisions, then it doesn’t really matter if everyone knows. Prices are still impacted in a predictable fashion.
At a minimum, a trader should think harder about implementing a trade that is counter to large flows. This is akin to swimming against a swift current. The NASDAQ bubble in the late 1990s is the classic example of when this dilemma played out for portfolio managers.
In a bubble-formation process, rational investors can reasonably assess that prices are too high compared to a fundamental price, but strong flows continue to push prices higher. Going with the flow can work for quite some time, but eventually the weight of the “fund flows edge” must be compared to the eventual convergence of price with a much lower intrinsic value.
Another complication with the market becoming efficient with respect to the fund flows edge is the lack of a comprehensive data source that accounts for flows associated with all asset allocators. Large institutions, such as pension plans, insurance companies and sovereign wealth funds, do not report their flows. Some data sources track mutual fund flows, but not ETF flows. Many institutions use private, separately managed accounts and limited partnerships, which are not tracked. Foreign investment flow data is often very coarse. All these issues can lead to difficulties developing a mathematical expression that can act as a “flows proxy” to trade asset classes, and thus complicates back-testing the effect.
Perhaps this is why the edge hasn’t been arbitraged away. There are also many nuances associated with using flows as a trading edge, which I’ll discuss later, and perhaps that’s where the edge is.
Where to Get the Data?
There are a number of data sources on flows, and all are expensive and substantially incomplete. Data sources include:
- Investment Company Institute (ICI)
- TrimTabs Investment Research
- Lipper and Morningstar
- EPFR Global
- Ned Davis Research
You can also find snapshots of intermediate-term flows by reading press releases from these organizations and trolling the web for reports on flows.
These data sources provide only part of the picture. Institutional investors, such as pension funds, insurance companies, sovereign wealth funds, endowments and foundations, can be a major source of flows. Corporate actions, such as stock buybacks, can also be important at times. Estimates of these flows must be accounted for.
An excellent source of information on institutional investors is a relatively cheap trade magazine called Pensions and Investments (P&I). It’s published twice a month, and I read it religiously because it provides clues as to what institutions are doing at the margin and why. There are many stories about how institutions are shifting their portfolio allocation from one asset class to another. P&I also has periodic issues tabulating the size of various institutions and their current asset allocation.
The bureaucratic way in which these organizations move, combined with career risk aversion among decision makers, generally leads to a herd-mentality associated with their allocation trends. The institutional data sources don’t provide flow data, but you can do the math to guestimate the magnitude of flows by multiplying total pension assets by an estimated percentage-shift divided by an estimated implementation time (such as a year).
Also consult the annual reports of thought leaders in the industry to get a leg up on allocation shifts, such as:
- Yale and other Ivy League endowments
- California Public Employees Retirement System (CalPERS)
- Government Pension Fund of Norway (Norwegian sovereign wealth fund)
Any approach to gain intelligence with respect to the gist of the flows picture should be pursued. When fund representatives visit our office, one of my favorite questions is “which of your strategies is receiving the largest inflows and outflows?”
Investment Flow Analysis
Investment flow analysis takes experience, skill and a bit of gamesmanship. It’s not enough to look at flows data, and I talked above about why data incompleteness makes this difficult.
What’s essential is understanding where the flows are coming from, what the motivations are, and whether the flows are large and are expected to continue. I use flows data to corroborate my view regarding the above factors. Many times there are crosscurrents in the flows picture among the various market participants. Then there is no trading edge, which is generally seen in the flows data.
What is large? That’s a good question, and the answer obviously changes over time as markets grow. The answer also depends on the liquidity of the asset class. For the extremely liquid treasuries market, the Fed’s QE purchases of bonds on the order of $50-$100 billion per month was still not enough for me to bet on treasuries using this trading edge.
For other asset classes, a net $20 billion per month provides enough incentive to investigate and analyze whether there’s a fund flows edge associated with the asset class.
To get better with this sort of analysis, a trader needs to learn as much as possible about the various asset allocators active in the markets. You need to be able to put yourself in their shoes, understand their problems and how they’re currently positioned in aggregate. If a new allocator comes to the arena, quickly get up to speed on how they operate and how they can be gamed.
In the next blog, I’ll provide some hypothetical examples of when this edge could have been used in the past.
Nuances and Implementation Hints
- Positive flows are a nice edge during bull markets, but usually these flows turn negative during corrections and bear markets. These short-term outflows are coincident with price and are mostly due to traders and hedge funds reacting to falling prices and also retail investor panic selling. If I’m long-term bullish on an asset class due to positive flows, I tend to ignore the negative signal associated with these short-term outflows. When the correction ends, assuming asset allocator motivations haven’t changed, the positive flows will eventually return to enhance performance during the next bull run.
- Negative intermediate-term flows are useful in all markets. Generally I tend to avoid these asset classes. I also tend to avoid large funds facing outflows due to poor performance, or if a popular manager has left.
- Similarly, you can expect a new fund opened by a popular manager to perhaps outperform as large flows support prices of its portfolio holdings. Compare the performance of the PIMCO ETF (BOND) when it first came out in 2012 with the similar open-ended mutual fund (PTTRX). Some fund families have a long history of introducing new mutual funds that subsequently receive heavy inflows from the firm’s other pre-existing mutual funds.
- Inflows into illiquid asset classes are a great opportunity to exploit this edge as the price impact is more pronounced. Flows into small cap or emerging market stocks will have a more pronounced impact compared to flows into extremely large and liquid markets, such as the S&P 500 or U.S. treasuries.
- As discussed in my Asset Class or Trading Strategy blog post, flows into high turnover trading strategies (such as hedge funds, managed futures and momentum funds) provide no such benefit. Flows into these trading strategies simply lead to poor future performance because these fund categories are more like trading strategies than asset classes. Over the last 10 years, there’s been an enormous shift of assets from stocks and bonds into hedge funds and alternatives. This allocation trend unfortunately did not provide an asset class flows trading edge.
- As with all trading edges, at times there are no opportunities – a situation that can last for years. If that happens, keep the fund flows edge in the trader toolbox for when a new opportunity arises in the future.
Following fund flows works as an asset class trading edge. I don’t expect this edge to be arbitraged away, because large price-insensitive flows are always going to move prices, and because comprehensive flows data is difficult and expensive to acquire.
If flows data became cheap and comprehensive, or if dedicated ETFs were developed to provide exposure to a “flows risk premium,” then it would be time to set this trading edge aside, possibly for good.
At this point, the flows trading edge requires a lot of skill to understand asset allocator motivations and develop a comprehensive educated guess of the flows picture. As with any trading edge, the faster we identify the opportunity, the better the results may become.
The fund flows edge can be used to improve the results of any intermediate-term trading/investing discipline, including value investing, momentum investing and trend following. A price trend that is aligned with a strong flows edge will be much more durable than simply looking at the price action alone.
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