Between the ubiquity of mutual funds and the ever-increasing popularity of exchange-traded funds, the monthly “fund flow” wrap-up has become a staple of Wall Street coverage.
And why not? The buying and selling of funds — which provide a way to make broad bets on various sections of the market, be it by asset size, asset class, sector, industry, you name it — help to tell a story of the market’s sentiment. U.S. equity funds saw heavy inflows for the month? It’s a good bet that investors were awfully bullish about U.S. equities.
But as far as the extent to which you and I should delve into these monthly number crunches, that’s it.
That’s because for one, fund flows — a measure of the past movement of money in and out of funds — are the very picture of backward-looking data. The adage analysts and financial product providers alike have driven into the ground is that “past performance is no guarantee of future results” — and it’s true. Sure, technical analysts might have a laugh, but ever-moving trading patterns are a different critter than, at their most frequent, weekly snapshots of who’s buying and selling funds.
More important, though, individual investors aren’t the only ones driving those fund flows in and out.
Institutional investors — hedge funds, big banks, mutual funds and other organizations that can throw millions, even billions of dollars at a single trade — control the lion’s share of the stock market. According to a report by Frank Aquila and Jinhee Chung of Sullivan & Cromwell LLP, “Shares representing more than 75 percent of the equity invested in publicly traded corporations are now held by institutional shareholders.”
But they’re not just buying and trading stock — they’re trading funds, too. In fact, a 2012 study by Strategic Insight showed that institutions held nearly half of all equity ETF assets. Deutsche Bank, in its own 2011 study, said institutional ownership is more prevalent in larger ETFs, at 63% of funds with $20 billion or more in AUM.
Why is that so important? Because of the big difference between these institutional investors and Joe Investor: The former is beholden to “performance,” while we’re beholden to ourselves. Whereas you and I are focusing at the end point of our investment horizon — be it 10, 30 or 50 years — hedge funds and the like need to have numbers to crow about on a much more frequent basis — yearly and even quarterly. That’s why you get outsized selloffs in big stock winners near the end of each quarter … and the same can sometimes occur in funds.
Take investment-grade bonds. The Wall Street Journal reported that last week, these bonds swallowed their second-worst outflow on record: a $2.32 billion plundering. Meanwhile, USA Today, in an article detailing bond funds’ record outflows in June, notes that the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) has sunk 8.3% since May alone.
But while cashing out of LQD and looking for more lucrative opportunities might make sense for a manager with a quarterly report to fill out, a panic sell might be pretty foolish for a person with another 30 years to retirement.
Let’s take the LQD’s largest decline in its history — a nearly 30% drop in price between June 2003 and October 2008. Now, it’s hard to sugar-coat a 30% drop regardless of time frame, but here goes:
Had you bought in at the peak, your yield would have been somewhere around 3.75%*, meaning it would take roughly eight years’ worth of income to make up that precipitous 30% price decline. Given that the decline occurred over just more than five years, those dividends wouldn’t have closed that gap — but it would’ve softened that blow from 30% to something more like 11%, or a -2% annual total return.
And remember: That’s where you’d be sitting had you bought high and sold low.
However, someone who had bought at that June 2003 peak and still held today would be looking at nearly 5% annual returns — sure, not beating stocks by any stretch of the imagination, but then, that’s not why you’re getting into investment-grade corporate bonds in the first place.
Bottom Line: Most of the time, individuals and institutions are playing with two entirely different clocks, and you and I often will have a lot more time to let an investment thesis play out, be it waiting for an asset class to turn around or just letting dividends do their thing. So let fund flows give you a lay of the land … and leave it at that.
*Yields likely would have been driven up during the 2003-08 decline as higher-yielding newer issues replaced older ones, just as they would’ve been driven down during LQD’s more recent ascent. 3.75% is used as a conservative, static estimate for these purposes.