Recent mutual fund flow data contain good news for stocks and not-so-good news for bonds.
This isn’t the conclusion you’d reach by focusing on the raw data themselves. Year-to-date, for example, according to EPFR-TrimTabs, U.S. equity funds (both open-end and exchange-traded funds) have experienced net outflows of $86.5 billion. U.S. bond funds, in contrast, have experienced inflows of $169.9 billion.
But fund flows often are best viewed in a contrarian way, as you can appreciate by looking at the chart below. U.S. equity funds experienced net outflows in each calendar year from 2016 through 2020, during which the stock market performed well. These outflows turned to inflows in 2021, just in time for 2022’s bear market.
Bond funds at least partially followed a contrarian script of their own. In calendar 2021 they experienced their largest net inflows in years. In 2022, they suffered their worst bear markets in decades, perhaps ever.
The relationship between fund flows and subsequent performance does not follow a mechanical timeline. Sometimes the inverse relationship manifests quickly, while on other occasions it can take longer. So the fund flow data don’t translate into any simple longer-term market timing indicator. Still, more often than not, huge inflows are followed by mediocre returns at best and often losses, while huge outflows are followed by decent returns — or better.
This relationship has been the subject of several academic studies. One, which appeared two years ago in the Review of Finance, found that, on average, the ETFs with the biggest outflows proceed to outperform the ETFs with the biggest inflows— for up to a year after these extreme flows.
Matthew Ringgenberg, a finance professor at the University of Utah and a co-author of this study, explained in an interview the likely sequence of events that leads to this underperformance: When investors (mostly retail investors) pile into an ETF, its price becomes too high relative to the net asset value of the stocks its own. This premium gets arbitraged away by specialized marketmakers (called authorized participants) who create new shares in the ETF.
Another study, which appeared last summer in the Review of Financial Studies, found one likely culprit: Investor exuberance for the hottest funds and ETFs. The study found that the narrowly-focused ETFs that are created to capitalize on investor fads, and which typically receive a big influx of cash soon after launch, lag the market on a risk-adjusted basis by 5% per year over the five years following launch.
A recent example of this phenomenon is investors’ obsession with artificial intelligence. A recent study in Finance Research Letters found that a stock performed better if it was owned by an ETF with “AI” in its name. This is reminiscent of the late 1990s internet bubble, when stocks would perform significantly better when their companies changed their names to include “dot com.”
These studies point to the basic contrarian lesson, perhaps best articulated by Warren Buffett, to “be fearful when others are greedy, and greedy when others are fearful.” The current fund flow data suggest that stock-market investors are more fearful than greedy. Despite the S&P 500
SPX,
gaining more than 15% so far in 2023, investors on balance have pulled money out of U.S. equity funds.
This is particularly encouraging from a longer-term perspective. Contrarians would be much more worried about the lasting power of this young bull market if retail investors had been quick to jump onto the bullish bandwagon. That they have not suggests there’s a strong “wall of worry” to support the bull market.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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