We often hear phrases like "money on the sidelines" in financial media but they feel like hand-way explanations for one of the most basic things we do as traders: follow the money. This is known as the flow of funds.
On any given day, more money might be flowing in or out of the stock market as a whole. Some sectors or industries might be more favored or disliked at the time. But when we smooth out the data by looking at it over several days, we see trends form.
For example, throughout 2020, there was a persistent flow of money towards tech stocks and other assets which benefit from coronavirus lockdowns while money was flowing away from travel and airlines.
Another example is the year 2021.
It broke records for the most cash invested in the stock market in the last twenty years. Observed visually, it was clear that something significant was occurring. It's no coincidence that the S&P 500 returned 27% over the year. Just look at the rate of change in fund flows:
Source: Bloomberg
This is pretty basic, right? But it always seems as such in hindsight.
Most of us miss these seemingly obvious insights when they matter: in the moment where we can profit from it. And I know, I'm laying on the hindsight pretty heavily here, cherry-picking two very obvious big investment winners over the last two years.
Simple concepts can be strong, however. Because fund flows data allows us to answer the prime question: which direction is money flowing in the market? It keys us into whether there's significant supply/demand imbalances that we can potentially take advantage of and profit from.
Today we're talking about following the flow of funds in the stock market. This involves tracking how much money is coming in and out of ETFs and mutual funds to deduce the areas where the most investments are being made.
How to Use Fund Flows Data
There's no right way to utilize fund flow data. As long as you actually have a repeatable process that makes sense, you can use it to spot trends early, or to spot overcrowding and act as a contrarian.
You can use it to trade the broad market, sector or industry funds, or even individual stocks. For example, if you see tons of money flowing into electric vehicle funds, you can use that as a tailwind to find a favorable entry point in your favorite electric vehicle stock.
If you like following market trends, you can look for sectors or industries where there's heavily increased interest and use that as one indicator, combined with the rest of your market analysis, to hop aboard the already moving train.
After all, this taps into a persistent behavioral bias in which investors quickly sell funds that they're losing money on, and hold onto their winning funds. Individual investors are basically trend followers, or so this study by Zoran Ivkovic and Scott Weisenberger concluded.
But contrarians can make money with this too because markets are kinda like boats. Once there's too much weight on one side, it starts to tip over.
This 2005 Yale study found that when retail investors are overcrowded in one area, like growth stocks, that it's highly correlated with negative future returns.
Mutual Fund Flows
In many ways, mutual funds are the passive investment vehicles of yesteryear. But they're still one of the largest asset classes, controlling $24 trillion in assets under management as of 2020. So their movements still impact the markets in a big way.
Mutual funds report the amount of money coming in and out of them on a monthly basis, making it simple to look at which asset classes or sectors investors are most interested in. In other words: it gives us a clue as to where the money is going.
One great source to find this data is Morningstar. They make monthly reports on broad market fund flows, as they did here for December 2021, and you find flow data for individual funds by going to the fund's page as I did here.
Another source for mutual fund flow data is from Yardeni Research, which puts out a weekly mutual fund flows newsletter. Here's an example of a chart from the newsletter:
Investors are buying emerging markets this week amid the bearish conditions in the US market. Let's take a quick look at a chart of EEM, the emerging markets ETF:
Looking pretty bearish, although some traders might find the potential support level around $47 enticing.
However, when we look at EEM's relative performance compared to SPY, we see significant relative strength in EEM. We do this by using a ratio chart:
ETF Flows
All trends point to ETFs eventually overtaking mutual funds as the old relics fade away, although mutual funds still have more assets under management than ETFs.
One of the great things about tracking ETF flows is that they're much easier to follow. Sources like ETF.com rank their entire database of ETFs according to which received the most inflows and outflows.
Let's take a look at ETF.com's top 10 list of creations and redemptions (with creations meaning inflows and redemptions referring to outflows):
We can make some quick insights from this, namely, that investors are buying the dip in semiconductors and gold. However, as you can see, most of the ETFs on this list are broad market indexes on equity or bond indexes. Really, what we're looking for here is more granular data on individual sectors to see where the relative strength in the market is.
Luckily at the top of the page, we can enter our own list of ETFs to track:
Here we're just tracking the major sector ETFs:
Financials (XLF) seem to be the standout winner for this week. So let's take a look at the XLF stock chart:
While it's been declining along with the rest of the market this week amid bearish conditions, if we look at a ratio chart, where we compare the performance of XLF to SPY, we notice that XLF's relative strength is strong:
Is this precisely because of fund flows? Of course not. But the fact that investors are soaking up supply at those lower price levels with aggressive inflows is an indicator that we might want to pay attention to financial stocks should they set up a favorable trading opportunity.
Bottom Line
Fund flow probably shouldn't serve as the bedrock of your trading system. It's too infrequently released and there's too many other factors to pay attention to.
I view it similarly to a stock screener, just as you don't blindly buy every stock that meets your screening criteria, you don't blindly follow fund flow data.
But it's excellent at giving you ideas of where the money is currently flowing, which can spark a great trading idea.
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