In the last blog, I discussed the trading edge associated with predicting investment flows. In this blog, I’ll provide examples using this trading edge to pick outperforming asset classes. Of course, this is a hypothetical exercise with the full benefit of hindsight, and as is often the case, flows may not be the only cause of the observed performance.
1995 to 1999
This era is widely recognized as the culmination of the 1982 to 1999 secular bull market in U.S. equities. As shown in Figure 1, it was a time when retail investors were obsessed with stocks as illustrated by the meteoric rise in CNBC viewership.1 Index investing was also becoming very popular, but at that time indexing solely meant investing in the S&P 500. Mutual fund managers were the investment stars of the era.
Figure 1. CNBC viewership history.1
Figure 2 from Ned Davis Research shows equity mutual fund net flows as a percentage of U.S. market capitalization from 1960 to present.2 These flows can be attributed primarily to retail investors, who throughout the 1990s powered a strong equity bull market. (more…)
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. (more…)