The Fund-Flows Indicator Is Behaving Strangely

A Venerable Pattern

Cash flows into (or out of) mutual funds have long been regarded as a meaningful investment signal. Twenty-five years ago, The New York Times marveled at how retail investors seemed to be driving stock prices. “Never before have we had a period where mutual funds have so consistently dominated the demand side of the market,” commented a Wall Street researcher, after July 1995’s equity-fund sales established a new monthly record.

Mutual fund flows, suggested the article, had helped the S&P 500 achieve its 3.3% July gain. But there was a catch to the good news: “Huge cash inflows into mutual funds are considered symptomatic of extreme optimism on the part of the public,” stated that same researcher. “That is viewed as a sign of caution by professionals.” A fund-company president agreed: “The excitement is always highest just before the roller coaster goes over the top.”

The excitement was only starting, as U.S. stocks had begun an extraordinary five-year run that continued into the next millennium. Mutual fund flows increased in tandem with equity prices. Equity-fund inflows set an annual record in 1995, exceeded that amount the following year, and were higher again in 1997. Inflows remained steep until 2001, when stocks were immersed in a bear market.

The experts had been too early for their advice to be useful, but broadly speaking, they were correct. Mutual fund flows had indeed been correlated with the stock market’s performance. High inflows presaged continued gains, while lower inflows (in those days, net outflows were rare) presaged trouble.

The explanation for the relationship between flows and performance went as follows.

1. Securities respond to investor demand. Thus, when equity-fund managers receive a substantial amount of new assets, they will probably inflate stock-market prices.
2. Mutual funds are an important component of investor demand. At year-end 1995, mutual funds possessed about 15% of U.S. equities and were growing their market share rapidly.
3. Mutual fund activity exemplifies overall retail investor actions. If everyday investors are aggressively purchasing equity mutual funds, they probably are also aggressively buying equities directly.

Something New
It’s time to re-examine those beliefs. To write that this year’s fund flows haven’t obeyed the expected pattern is to gravely understate the matter. In January and February, U.S. equity mutual funds and exchange-traded funds suffered redemptions even as stock prices rose. The funds then received their only month of positive net inflows during March, when equity prices plummeted, before promptly resuming their outflows just as the powerful stock-market rally began.

The discrepancy was at its greatest this summer. The S&P 500 followed its 5.6% July return with a 7.2% increase in August, the only stretch during the past five years when the index gained at least 5% in two consecutive months. Those two months were the very worst for equity-fund sales: July set a five-year low with $45 billion in net outflows, and August exceeded that figure. In 2020, the more heavily that equity funds have been redeemed, the better that stocks have performed.

The correlation between bond-fund inflows and bond-market returns hasn’t been quite as consistently negative, but neither has it been positive. Fixed-income funds enjoyed healthy inflows in January and February, when bonds performed well, thereby temporarily maintaining the link. However, when high-quality bonds rallied in March, bond funds endured huge outflows. They have since recovered to once again post strong inflows, while bond prices have trod water.

The Skeptical View
This year’s results call into question those three tenets.

1. Securities respond to investor demand. True, but the link between cash flows and security prices is not straightforward. In addition to the amount of cash that enters or exits a marketplace, how transactions are conducted is also important. Trade orders that are executed gradually don’t affect prices as much as those that are executed aggressively. In the latter case, a small stone can create a big ripple.
2. Mutual funds (and ETFs) are an important part of investor demand. That remains correct. In fact, equity funds account for much more of the U.S. stock market today than they did in 1995, as they now possess a 25% market share. However, what affects security prices is not the size the account itself, but rather the size of changes to those accounts. And those have shrunk, as fund inflows/outflows are smaller today--as measured by percentage of the stock market’s capitalization--than they were 25 years ago.
3. Fund activities exemplify overall retail investor actions. Perhaps not. This tenet can neither be proved nor refuted, because there is no reliable aggregate data about retail buyers’ direct-stock habits. Anecdotally, though, one should be suspicious. Retail brokerage firms reported skyrocketing trade activity during 2020’s second quarter, when equity funds were in redemptions. For example, TD Ameritrade added 661,000 accounts from April through June, while processing a record number of trades. Newcomer Robinhood doubled its first-quarter trading revenue.

In short, fund flows may no longer reliably measure the retail investor’s pulse.

Wrapping Up
Sometimes the old rules cease to apply. Investors once pored diligently over Federal Reserve releases about changes in money supply, believing them to offer valuable evidence about future inflation. They no longer do, those links being apparently severed. The rise of mutual fund flows represented another turning point. The New York Times reporter in that 1995 article wrote, “All this has left Wall Street professionals wondering if this time is different.”

That time was different. A generation before, mutual fund flows meant nothing to security prices. By 1995, they very much did. I do not claim that the pendulum has reverted entirely. Publicly traded funds are too large not to matter. However, the relationship between their flows and the performance of financial assets has been downright wacky this year. More evidence is required before concluding that the fund-flows indicator has outlived its usefulness, but until the signal becomes more reliable, its pronouncements should be consumed with a large spoonful of salt.  

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.