Thursday, August 14, 2014

A Primer on Fund Flows

You might have seen a chart that looks like the one below (original link is here). It shows "net new cash flow" for domestic equity funds. And the message from the chart seems to be that domestic equity funds are seeing large outflows. In other words, this is a bull market in which Main Street America is not participating.

The subtext is that once mom and pop decide to get back into the market, it will really take off.

SPX is up nearly 3 times since 2009 and it has doubled since August 2011. Does it make sense that cash has been flowing out of funds most of the time that the market has been going up?

The obvious answer is no. So what is the story behind the chart above?

The chart only includes mutual funds. It's therefore missing the fastest growing part of the market today, namely ETFs. If you include ETFs, you get a completely different picture: "domestic equity funds" are seeing large net inflows. More than $300 billion flowed into funds in 2013 alone (data from ICI).

Investors have several ways to invest in domestic equities through a fund.

The main one is still "active" mutual funds where a fund manager picks stocks. While enormous, these funds are now a declining part of the business (green line above).

In it's place are "index" mutual funds that invest passively in the S&P, the Dow and other indices. These are growing steadily (blue line above).

ETF assets may still be smaller than mutual funds but they are the largest source of growth. Well over $500 billion has flowed into domestic equity ETFs since 2007 (red line above).

Not included in the chart above is another large source of net inflows into domestic equities: "hybrid" funds that invest in both equities and bonds. More than half of these fund's assets go into equities. Over $70 billion in net new cash went into these funds last year. As the population ages, hybrid funds will likely become an increasingly popular way to invest in equities (chart from ICI).

There are also Closed Ended Funds (CEFs) but these are a relatively small part of the overall pie.

Outside of funds, individual investors also increasingly buy individual stocks. Technology has made this easier and less expensive. These flows are not counted in any of the above.

Finally, individual investors are also increasingly buying equity mutual funds focused on non-US markets. About $200 billion net new cash has been added to these funds since 2013 started.

When you include all the ways individual investors can invest in equities through funds, the message is the opposite of that of the first chart above. In fact, the biggest story is that investors' holdings of equities (both ETFs and mutual funds) relative to safe "money market" assets (i.e., cash) are at a substantial new high (chart is through June 30, 2014; data is from ICI).

In the first half of 2014, domestic equity mutual fund flows were negative but the amount was a small fraction of the net cash inflows into ETFs, hybrid and world equity mutual funds. The biggest flow was out of money markets to fund these new equity investments; that's the main conclusion you should take away from this story.

The simplest explanation is usually the correct one: the indices have doubled in the past 3 years because investors have been putting cash into the market at a furious pace. As the data show, they are invested.