Investing: follow the flows

While it is important and interesting to watch the flows, don't let market sentiment push you away from your long-term strategy. By Todd James

It is interesting to watch the flow of funds and where global investors are moving their capital; what asset classes are being bought and which are being sold. 

Most investors buy the momentum of demand, but historically speaking following the “hot money” (positive inflows) has been the wrong strategy to follow.

Year-to-date there have some very clear trends.

Flows

On the positive flow front, direct gold-related investments have led the way with respect to inflows. This action shows the relative risk aversion which most investors have felt over the past 10 to 12 months.

On specific asset classes, US fixed income and US equities have attracted the biggest inflows of capital (after gold) into open-ended mutual funds and ETFs. Again, this isn’t too surprising given the positive returns seen in those respective asset classes.

We have also seen a modestly positive inflow into emerging markets (EM) primarily with EM equities and, more recently, into the fixed income space.

On the negative front, European and Japanese equities have both seen significant outflows of investment capital. More recently, currency-hedged equity funds have seen outflows, as have financials.

On the financials front, the outflows can be attributed to the negative news from Deutsche Bank, Wells Fargo and the concern that other banks may follow, especially in Europe.

Last month, there was a spin-off of the REIT sector from the US financials (REITs are no longer part of the US financial index) which has had a rebalancing impact, but may provide further weakness to the financial sector.

We have also seen a continuous outflow from listed hedge fund-replicator strategies. Hedge funds are finding it more and more difficult to generate above-average returns. Whether it’s the lower volatility or the fact that returns have been following indices more closely, clearly hedge fund strategies have not been working. I wouldn’t yet declare them dead or broken, but they are obviously not working in the current market environment.

This under-performance (and thus outflows) also follows through to smart beta-based funds. Investors (and issuers of smart beta funds) have bought into the concept of smart beta, but when returns don’t materialise, they are quick to move away. Again, I wouldn’t throw them out altogether, but suggest using them as a complement to more mainstream indices and strategies rather than as a replacement.

One of the only smart beta products that have seen positive inflows while still under-performing has been low volatility strategies, which we have talked about before in this column. Investors are nervous and are willing to give up some returns if the end results are lower volatility.

This may seem self-defeating, but it is good to see investors thinking about both sides of the spectrum – risk as well as return. Too often we focus on chasing returns without managing the risk.

In general, ETFs are on pace for a record year with respect to inflows. More and more investors see the value in long-term planning and investing passively, without the thrill and disappointment of chasing alpha. This, in my opinion, is a good thing.

Reading the signs

What does all this mean for investors? Again, historically it has proven an under-performing strategy to buy into asset classes and sectors with positive flows and sell those with outflows.  

I would agree with avoiding the smart beta and hedge fund-based strategies for the rest of this year. In fact, it appears that that the winning strategy for 2016 until now – and possibly until the end of the year – is to follow a straightforward passive index strategy.

Generally speaking, I am positive on the market, but next week Q3 earning season opens and it could set the tone for the for the last two-and-a-half months of the year. And while the market isn’t expecting much, any positive surprises could continue to support the market right into another Santa Claus rally.

Don’t forget, historically speaking, November and December are the strongest two months of the year, in terms of returns and lower volatility. While history is no indication of future returns, will Santa Claus let us down this year?  (I hope not.)