Each month the Investment Company Institute publishes data for net money flows into and out of mutual funds available in the United States which we present here.  They have turned positive after months of massive outflows.

While ETFs are quite popular and increasingly so, mutual funds still are where the bulk of retail investor fund assets are found — 401-k plans being a major factor.  That makes data on mutual fund money flows a good indicator of the behavior of the “average Joe” investor.

Here are three charts showing the mutual fund net money flows from 2002 through April 2009.

The first chart shows the total flows for equity mutual funds.  The second chart shows the 3-month moving average of net flows into those funds that invest primarily in the US and into those that invest primarily on a world or international basis.  The third chart shows the cumulative net flows for each year and this year-to-date for (1) total equity funds, (2) primarily US equity funds and (3) primarily world or international funds.

A fourth chart, plots the share prices of a total US stocks mutual fund (VTSMX) and a total non-us stocks mutual fund (VGTSX) for comparison with overall mutual fund money flows.  The ETF equivalent of the US mutual fund is VTI.  The rough equivalent of the non-US mutual fund is VEU.

The general shape of the share price curves are quite similar to the general shape of the annual cumulative money flow histogram.  That is a demonstration of the obvious, which is that prices respond to money flows.

If you know where the money is going, you will know where the prices are going.  That is the logic of indicators based on volume for individual securities.

click images to enlarge

The first chart of monthly overall flows gave a pretty good warning shot with a $46 billion outflow in January of 2008, nearly as large as the $52 billion outflow at the market bottom in 2002 — yet that was in a still generally rising market.  That kind of information divergence is typically an important signal that something is wrong.  A rising market and retreating fund inflows cannot both be right.  One had to be wrong, as was clearly demonstrated later in 2008.

The funds outflows in the second half of 2008 began in earnest in July and didn’t abate until January 2009, then back in the tank for the two months of February and March, before turning positive again in April.  May data has not been released, but it will surely be a positive number; probably stronger than April.

However, two months of positive inflows is not proof of a bull.  A bull would string more months together with increasing volume.  The last bull produced 40 consecutive months of positive flows before a single negative month, and then 17 more consecutive months before the situation began to deteriorate during 2007.

On a yearly cumulative basis, the non-US inflows were larger that the US inflows in the “good times”, but in these “bad times” the US inflows are larger than the non-US inflows.

Nonetheless, emerging markets are outperforming the US.  This is due to the small relative size of the emerging markets.  It takes a much smaller flow of money in or out to dramatically move emerging market share prices.  That’s why they are higher Beta than US stocks.

The flows to emerging markets (which may be a larger share of non-US flows than in prior years) have driven up emerging market share prices much faster than US or developed non-US markets during this current rally.

Emerging markets were the stars before the crash.  They lost the most from peak to trough, and on a one-year basis, but were not the biggest losers over a three-year period — in fact they are the greatest gainers over three-years (net positive, while the US and developed markets are net negative over three-years).  Emerging markets are once again the stars over the short-term.

Given the long-term transfer of manufacturing, economic and financial power toward Asia, as well as the sorry state of affairs in the US and Europe, we think increasing ultimate allocations to emerging markets at the expense of developed markets makes reasonable sense — provided you can take the bumpy ride.

Here is how emerging markets (proxy VWO) have performed over three time periods relative to US stocks (proxy SPY) and developed non-US markets (proxy EFA).

VWO, SPY and EFA (3 years monthly)

VWO, SPY and EFA (1 year weekly)

VWO, SPY and EFA (3 months daily)

Richard Shaw
QVM Group LLC

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