Follow the Flows

iStock_000015692225_LargeIn 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. (more…)