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What are fund flows telling us about trends and risks in the global stock market?

What Are Fund Flows Telling Us About Trends and Risks in the Global Stock Market?

Key Points
  • The trends in money flows this year show a rising overall inflow of money as investors take note of better overall stock market performance.

  • Investors are flocking to ETFs while shunning mutual funds, but ETFs do not fit the classic profile of a potentially damaging bubble.

  • The money coming into ETFs is flowing into a broad range of stock markets featuring a preference for international stocks and revealing a surprising disconnect with the performance and geopolitical risk of the underlying markets.

This commentary is usually devoted to assessing the many reasons global markets may rise or fall.  But at the heart of it, all markets come down to just one thing: buyers and sellers. Taking a look at where market participants are putting their money can help to spot trends and evaluate risks.

Buyers again

Consistently predicting what markets will do is hard, if not impossible. Predicting investor behavior, on the other hand, can be surprisingly simple. Without the aid of advice, investors often tend to chase returns. The rolling five-year return has most closely mirrored investors’ buying and selling of stock funds (mutual funds and exchange traded funds (ETFs) combined), as you can see in the chart below of the past 10 years. In our 2017 outlook, we pointed to the turnaround in the five year return for global stocks as a clear signal of the rebound in net buying of equities that has taken place this year.

Buying has returned in 2017

equity fund flows

Global stock market represented by MSCI AC World Index.
Source: Charles Schwab, Bloomberg and Investment Company Institute data as of 8/5/2017.

 

Buying ETFs

More specifically, U.S. investors are buying ETFs while selling mutual funds. Both mutual funds and ETFs that invest in stocks saw similar net money flows for many years, but that began to change a few years ago with money flowing out of mutual funds and into ETFs, as you can see in the chart below. 

Money flowing from mutual funds into ETFs

cumulative ETFs

Source: Charles Schwab, Bloomberg and Investment Company Institute data as of 8/5/2017.

ETF bubble?

The surge in money going into ETFs has led some market participants to question whether it might be a bubble. Since the low in 2009, ETFs that invest in stocks have seen assets rise about 500%. This strong run is due to stock market appreciation, money moving from mutual funds into ETFs, and net new money coming in. 

As you can see in the chart below, bubbles have inflated 1,000% over 10 years before bursting, cutting prices by more than half in the following two years. We examined some potential bubbles and the risk they pose to the broad markets and economy in a recent commentary. Examples of these types of asset bubbles that have burst over the past 20 years include: 

  • the technology, telecommunications and media stocks of the NASDAQ Composite Index, 
  • crude oil,
  • precious metals, 
  • homebuilder stocks in the S&P 500 Homebuilding Index. 

Both the 1,000% gain and the 10 year buildup are important to how embedded the bubble becomes in the markets and economy when it bursts. 

ETFs don’t appear to be a bubble ready to burst

Bubble chart

Oil prices measured by West Texas Intermediate crude oil first month futures. 
Silver price measured by spot price per troy ounce. 
ETF equity assets based on US-based ETFs tracked by the Investment Company Institute.
Source: Charles Schwab, Investment Company Institute and Bloomberg data as of 8/7/2017.

Applying the same classic profile of a bubble to ETFs it appears that since their financial crisis low point in early March 2009, ETFs have not seen the 1,000% growth we have seen in destructive bubbles in the past. It is important to recognize that ETFs are merely one of many vehicles to invest in the stock market and, therefore, a bubble watch should be on the underlying assets in those ETFs (like tech stocks in 1999, for example)—not the vehicles themselves.

ETF trends

The money coming into ETFs is flowing into a broad range of stock markets featuring strong preference for international stocks and revealing a surprising disconnect with the performance and geopolitical risk of the underlying markets.

Investors have been favoring international ETFs. Although ETFs (including those based outside the U.S.) that invest in U.S. stocks gathered more assets so far in 2017 than any other individual country or region ($95 billion), most of the inflows were into non-U.S. ETFs ($267 billion). This 3-to-1 ratio of international to U.S. inflows is illustrated in the chart below.

Investors favoring non-U.S. ETFs

ETC net inflows

Includes ETFs based in all countries.
Source: Charles Schwab, Bloomberg data as of 8/7/2017.

The net inflows in 2017 as a percent of total ETF assets by region or country:
•    5% to the United States
•    20% to international developed markets
•    16% to emerging markets.
The developed country with the largest ETF inflow was Japan, while the most favored emerging market was India. There were also outflows this year from many countries and regions. The developed market with the largest outflow was Hong Kong and the emerging market with the greatest outflow was China.

ETF flows by country and region year-to-date in US dollars

table 1
table 2

Includes ETFs based in all countries.
Performance reflects total return of representative MSCI index.
Source: Charles Schwab, Bloomberg data as of 8/7/2017.

Money flows in and out of different country ETFs do not appear to be driven by—or driving—country performance. This is surprising since overall money flows seem to be tied to changes in the rolling five-year return of the global stock market. Yet a few examples make this divergence clear. While strong net flows this year into Spain and India mirror strong performance among stocks in those countries, outflows from Mexico and Hong Kong are in contrast with the strong performance in those markets this year. Also, it's worth noting that the most favored countries for net inflows, the U.S. and Japan, fall near the middle of the range of country performance. This suggests the ETF flows are not “hot money” that could quickly reverse if performance stumbles, but instead driven by fundamental reasons or a desire for the greater diversification these markets now provide.

The flows show that investors do not seem worried about geopolitical events. This year has seen solid inflows to markets that are geopolitical hotspots. For example, Italian elections in early 2018 do not seem to be holding back inflows, Greece’s ongoing debt problems haven’t staunched inflows, and the threat posed by North Korea’s nuclear ambitions hasn’t kept money from flowing into South Korean funds. Yet, it is easy to imagine this money flow reversing quickly were a negative geopolitical event to take place, or even if the odds of an event appeared to rise sharply.

Trends and risks

The trends in money flows this year show a change to a rising overall inflow of money as investors take note of better overall stock market performance and a preference for ETF that invest in non-U.S. markets. However, the rising inflow to ETFs does not appear to present the risk of a potentially destructive bubble. The underlying distribution of money flows appears to be driven by fundamentals or diversification, rather than purely by performance or geopolitical risk aversion, suggesting a trend that is more deeply rooted (although some markets may be vulnerable in the event of an escalation of geopolitical risk). Investors may want to consider these trends as they consider the global diversification in their own portfolio.
 

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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

The MSCI ACWI captures large and mid cap representation across 23 Developed Markets (DM) and 24 Emerging Markets (EM) countries. With 2,497 constituents, the index covers approximately 85% of the global investable equity opportunity set.

The NASDAQ Composite Index is a broad-based capitalization-weighted index of stocks in all three NASDAQ tiers: Global Select, Global Market and Capital Market.

Standard and Poor's 500 Homebuilding Index is a capitalization-weighted index designed to represent the performance of stocks in the Homebuilding sub-industry of the S&P 500 Index as per the Global Index Classification Standard (GICS).

(0817-7HU9)

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