The Mutual Fund Flows Paradox

Investing Caffeine April 23, 2012

April 21, 2012 at 11:26 pm 8 comments

How is it that the stock market has more than doubled over the last three years, when investors have been dumping stocks like they are going out of style? If you don't believe me, and you think jovial investors are jacking stocks higher, then please explain to me why billions of dollars are hemorrhaging out of equity funds on a monthly basis over the last five years (see Fund Flow data chart below)?

Source: Calafia Beach Pundit

If by small chance you buy my argument that skeptical investors continue to doubt the sustainability of the three-year doubling in the stock market, then why is the Volatility Index (VIX) trading like investors are sunbathing at the beach while licking lollipops? For those not keeping score on the VIX (see also The VIX and the Rule of 16), typically a reading below 20 is interpreted as investor overconfidence and/or complacency. On the flip side, readings above 20 usually indicate pessimism or fear.

As you can see from the chart below, we have spent a good portion of the last few years on both sides of the 20 mph VIX speed limit, and currently at a reading of about 17, investors have slowed down to enjoy the scenery.

Source: Yahoo! Finance

So with massive selling and a cheery reading on the VIX, how can these bipolar data-points be reconciled? Therein lies the "Fund Flows Paradox."

Take Me Out to the Ballgame

If you equate equity investors to fans at a baseball stadium, the fund flow data clearly shows investors are tired of losing money and have been leaving the game in droves. Instead of staying at the equity baseball stadium, those fatigued stock investors have decided to head over to the adjacent bond arena. The equity stadium will never completely be empty because financial markets always have speculative traders. In baseball terms you can think of these short-term traders as the emotionally volatile die-hard fanatics, who will stick around regardless of whether the home team wins or loses.

So while sentiment gauges like the VIX, or sentiment surveys conducted by AAII (American Association of Individual Investors) may be temporarily flashing contrarian bearish signals, one should be cognizant that these data points do not include the petrified opinions of investors who have raced out of the stadium. Eventually when the home team's winning streak is long enough, investors will return back to the stadium from the bond arena. While there is no sign of individual investors coming back to the stock game anytime soon, in the meantime patient and disciplined investors have had plenty of opportunities to take advantage of. With massive numbers of individual investors and sellers sitting on the sidelines, the markets require relatively little buying to push prices higher.

Over the last few years, not only have equity valuations been broadly reasonable, volatility spikes during the last few summers have also created amplified opportunities. With the wall of worries currently blanketing traditional and new media headlines (i.e., European crisis, U.S. election uncertainty, unsustainable and slowing profits, pending tax cut expirations, Mideast turmoil, etc.) there is no sense of urgency to pile back in to the equity markets.

The doubling in stock prices have occurred on low volumes, largely on the backs of a smaller institutional investor base, not to mention high frequency traders and speculators. While sentiment surveys may currently provide some insight into short-term equity trader attitudes, don't let these volatile and unreliable data cloud the true underlying pessimism of the masses who have left the stock stadium in large numbers. Trillions of dollars remain on the sidelines as potential fuel for future equity appreciation, once confidence returns.

Opinions are interesting, but actions speak louder than words. Spend more time looking at the actions of the fund flow data, rather than the opinions of various short-term sentiment surveys or short-term options trader statistics. Adjusting your focus to investor actions and behavior will provide a truer gauge of overall investor sentiment and assist you in solving the "Fund Flows Paradox."

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in VXX, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC "Contact" page.

Entry filed under: Education, Themes - Trends. Tags: AAII, Europe, fund flows paradox, ICI fund flows, Mideast, taxes, VIX, volatility index.

Sidoxia’s Investor Hall of Fame

[...] A look at the “fund flows paradox.” (Investing Caffeine) [...]

[...] April 21, 2012 at 11:26 pm Leave a comment [...]

Timely and perfect game stock analogies in here. Well done. “Trillions of dollars remain on the sidelines as potential fuel for future equity appreciation, once confidence returns.” A bit perplexed about this because money never leaves the game, just as players in the dugout whose team is at bat are still playing. Investors have been leaving because they realise thateven good fund managers over the long term cannot beat their benchmarks owing to multiple reasons, fund expense being the primary one.

Keith:

Thanks for the note. Agree with your fund managers underperformance analysis (see also Charles Ellis article: http://investingcaffeine.com/2011/01/05/winning-the-loser%e2%80%99s-game/ ). May be a little metaphor mixing by me, but by money leaving the game I was trying to refer to all the cash in checking, savings, money market & Treasuries. If the markets continue to appreciate (win), those fearful dollars will eventually come back to the game, greedily chasing returns. If markets tank again like the bears think, then the cash will cozily wait on the sidelines.

On dark pools, these are institutional trading platforms for individual securities and should have little to no impact on fund flows in my view, but a larger impact on the fund flows data is the rise of ETF investing and trading. My two cents…

~WS

http://www.eurasiareview.com/05032012-mom-and-pop-investors-call-it-quits-oped/

Thanks Keith! A well articulated bear case. I’ve listened to these bear arguments for the last three years and they’ve been continually wrong (absent the summer sell-offs). Maybe they’ll be right this year??

~WS

[...] Fund Flows Paradox – Investing Caffeine Aktiemarknaden (USA) har mer än dubblats de senaste tre åren. Hur har det gått till när [...]

The Mutual Fund Flows Paradox

Related Articles