Fund Flow

Despite skyrocketing investor enthusiasm, buy-write strategies are complicated investments with skewed payoff structures that muddle the interpretation of past performance, because returns depend on market conditions.

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After years of wandering in the wilderness, Japanese stocks are leading the world’s developed markets higher in what has been a robust opening half of the year. The table shows Japan leading the world’s ten largest developed markets (as measured by the MSCI family of international indexes) with a 24% local currency return through June, easily outpacing the pack. Even as the MSCI USA index gained 17% by successfully “fighting the Fed” this year, Japan surged another 7% beyond that outstanding result.  We were curious to understand the nature of Japan’s spectacular run in 2023, looking to identify the drivers of this strong and relatively quick jump higher.

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The ETF concept began as a vehicle to provide low-cost access to a broad market index, and the terms “passive”, “cheap”, “index”, and “ETF” were often used synonymously. However, ETFs soon evolved into specialty funds that allowed investors to take focused active tilts in sectors, styles, and countries; a landmark shift away from the notion of passively investing in the total market.  These specialty funds are easy to trade and tax efficient, but they do not fall under the labels of cheap, passive, or broad market.

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We’ve noticed a small segment of equity ETFs, designated as “thematic,” that is increasingly gaining popularity. Thematic ETFs invest in baskets of stocks that share narrowly-defined business enterprises outside of the standardized GICS methodology.

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High growth rates, innovation, and disruption are defining traits of the companies that have powered the market to recent highs, and the ARK Innovators Fund (ARKK) is an example of today’s enthusiasm for visionary growth stocks. Recent returns and growth in AUM have been nothing short of spectacular, and ARKK has become symbolic of today’s style of new-era growth investing.

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In April 2018, armed with a large number of ETFs and long-enough historical data, we applied our back-testing methodology for individual stocks to the universe of ETFs to determine if the same (or some) of those components could useful for assessing ETF performance prospects. One of the factors we reviewed was fund flow (adjusted by AUM), which revealed that those ETFs experiencing the largest asset inflows proceeded to significantly underperform.

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Pfizer’s November 9th announcement of an effective COVID-19 vaccine triggered the most extensive one-day rotation in style factors we have ever seen. Investors flipped from Large Growth—the market’s dominating style over the past few years—and found new friends in Value and Small Cap. This rotation continued through November, to the point that Value and Small Cap each had their best single-month return in 30 years.

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Much of what we think “we know” about the bond market says yields should be headed higher.

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We found that ETFs with the largest one-month, two-month, and three-month fund inflows underperformed going forward. When further broken down by sub-asset class strategies, this pattern is pronounced among equity ETFs, while fixed income ETFs do not appear to be affected by fund flows.

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Bond funds (including ETFs), foreign-focused equity mutual funds and domestic-focused ETFs are the only categories capturing positive cash flows YTD.

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The “cash on the sidelines” is a Supply/Demand argument that we’ve struggled with even in the most bullish of times; every purchase of a security is matched with a sale. But even taking the argument at face value, current holdings of retail investors and mutual fund managers suggest that the cash left the sidelines long ago.

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Within two broad categories – domestic equity funds and bond funds - mutual funds versus ETFs continue to display opposite flow trends.

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Bond mutual funds continue to capture net inflows while their ETF counterparts have seen net outflows for three straight weeks. Domestic equity mutual funds see more net outflows, but (barely) hang on to positive YTD flows.

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Bond ETFs, Domestic Equity Mutual Funds and Money Market Funds see weekly net outflows, while all other broad categories experience net inflows.

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Outflows From Domestic Equity & Bond Funds Continue; Foreign-Focus Funds Still See Inflows.

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Year-to-date, equity funds are cash on par with those of the 2000 tech bubble, while bond mutual funds are experiencing net cash outflows for the first time in a decade.

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Funds of funds, particularly target date funds, are growing rapidly and are now large enough to have a measurable impact on underlying fund flow trends.

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Most noteworthy this week was a combined estimated $13.5 billion exiting bond mutual funds and ETFs on a net basis.

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