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What Every Investor Needs to Understand About Inflow and Outflow

02/14/2019

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Inflows and outflows to US equity markets are an important and misunderstood factor driving portfolio returns.
Investors often attribute the performance of any given stock to the underlying company’s operating results and the market’s assessment of their business prospects. These are certainly central, driving factors, but the vast majority of equities are correlated to their peers in an industry, sector or market.
Even companies that are relatively insulated from recessions still experience major valuation declines during market crashes. Similarly, a charging stock market has helped propel most stocks upward during the bull period from 2009 to 2018.
The dynamics that control market-wide trends are therefore very relevant for any equity investor. Markets for capital function with the same fundamental mechanics as markets for any other good or service. Demand for products drive prices higher, assuming supply remains materially unchanged.
Therefore, capital market inflows and outflows play a major role in portfolio returns on the macro level.

Allocation

Investors and portfolio managers benefit from an extremely large investable universe. Even excluding alternative asset classes, securities and currencies are available around the entire globe. Communication technology and financial innovation have enabled capital flow with relative ease and efficiency between continents and across borders.

This creates a competitive environment, in which asset managers can control the exposure to any economy or region. For example, if macroeconomic indicators are uninspiring in the European Union or in China, but the US economy has a robust outlook, it is likely capital will flow toward securities in the US.

These factors would cause prices to rise due to market mechanics.

Within each geography, the same decisions are made across asset classes, sectors, industries and investment vehicles. If inflation expectations rise, holding cash becomes costlier, and business ownership is generally used to offset inflation risk.

Low interest rates in the US, initially spurred by the Federal Reserve’s slashing of the federal funds rate and quantitative easing program, encouraged capital flows toward growth assets such as equities. Fund flow data from ETF.com confirms these trends. Flows to the largest US equity ETFs were substantially higher than that to bond ETFs between 2012 through 2017.

Recent Trends Drive Stocks Higher

Investors can analyze capital flows to understand the roles they have played in their own returns.

ETFs have been taking market share from mutual funds for several decades. ETFs offer liquidity and some tax advantages over mutual funds, and these characteristics paired with the rise of passive investing have made ETFs a very popular investment vehicle.

The total asset value of mutual funds in the US is still much higher, but ETFs are quickly taking share. The total asset value of these pooled vehicles was below $6 trillion in 2000, none of which was held in ETFs. Combined assets have since grown to $19 trillion, nearly $4 trillion of which are ETFs.

Inflows from other countries helped to drive the US equity market from 2009 to 2015, which experienced net outflows in 2016 and 2017 before reversing again to inflows in 2018. Net equity issuances did not keep pace with overall inflows, which drove stock prices higher. Investors should note that foreign inflows to US equities have been dwarfed by flows to debt and alternative investments.

According to JP Morgan’s Guide to the Markets, the forward price-to-earnings ratio for the S&P 500 rose significantly from around 10 in 2009 to a recent high of nearly 18. While growth expectations have continued to improve, stock valuations have still grown higher. This indicates that the price being paid is outpacing the underlying business fundamentals, a situation made possible by sustained inflows to equities.

US equities, ETFs and mutual funds all benefited from catalysts driving inflows for nearly a decade following the 2008 financial crisis. Shareholders no doubt enjoyed the stimulus from that capital injection, but an extended period of favorable macroeconomics may have fostered unreasonable expectations among investors.

A False Sense of Security

Many investors have been successful with indexing and US mutual funds. Indeed, the body of research on the topic indicates that passive strategies are better options during bull markets.

However, cyclicality in the global macroeconomy and capital markets makes it a near certainty that these conditions will change at some point. Rising speculation that the bull market is reaching maturity suggests that the shift may occur sooner rather than later.

Higher interest rates should encourage capital to flow into bonds, money markets, certificates of deposit and savings accounts. Capital will eventually flow overseas, and investors might begin to look more favorably upon active strategies if indexes start to decline.

Strategies that have been considered universally sound for numerous years may begin to seem less ironclad if US equities begin experiencing outflows. The impact could be especially acute among ETFs.

A Balanced Approach

It is hard to disparage a measured allocation approach that is designed to avoid failure in any circumstances.

Even if the recent trends in capital flows reverse sharply, it would be unwise to ignore the successes of strategies that grew prominent over the past decade. Passive indexing has merits, ETFs have some very attractive qualities, the US is one of the most reliable economies globally, and equities have traditionally delivered higher returns than bonds.

Similarly, investors would be wise to recognize the value of alternative strategies that delivered strong results in the past. Passive strategies have only been popular for a single market cycle, and many of the current shareholders have not experienced a sharp market decline with an index fund-heavy portfolio.

Actively managed funds generally retained more of their value during the 2008 market crash, a fact not often cited by proponents of low-cost alternatives. The sting of a correction might demonstrate the value of loss mitigation strategies offered by active management.

Passive and tactical allocations are not mutually exclusive at the portfolio level. Investors can embrace both strategies to complement their diversification across geographies, asset classes, securities and sectors. A blended approach can help limit expenses and dampen downside risk.

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