What a wild February. After a few years of exceptional returns on the market, we’re finally starting to see some cracks on the surface. Obviously, as long-term investors, we really don’t care too much about short-term fluctuations. In fact, we should welcome market volatility, as it allows us to accumulate funds at cheaper prices.
The cheaper we can get an asset for, the higher our future expected returns will be, especially when we’re talking about broad-based index funds.
I’m going to do something a little different for this month’s newsletter. Typically, I’ve focused my attention on an educational piece of content followed up by some funds to potentially buy/add to your watchlist.
In this month’s newsletter, I really want to focus on where the money is flowing these days and whether or not we should try and take advantage of it.
If you like this newsletter, make sure to hit the reply button and let me know. This is still a relatively young platform that will undergo many improvements as we move forward. However, most of the improvements will be made via member feedback.
Let’s get started.
Incorporating fund flows into your ETF strategy
Fund flows are an important concept when it comes to ETF investing.
Sure, if you’re absolutely insistent on a set-and-forget strategy of a few funds, you may not find much use for them. However, if you’re looking to squeak out a bit of an edge, following the money can be a solid strategy.
Fund flows are exactly what you’d think they would be. Money flowing in and out of exchange-traded funds.
It can give the savvy investor an idea as to the broader sentiment of the market and what both institutional and retail investors are thinking.
These fund flows are generally difficult to come buy. VettaFi’s ETF screener charges you $200 per year to unlock fund flow data.
Here at ETF Insights, you can access fund flow data via our ETF screener, as it is included in your subscription.
Alternatively, many major banks put out fund flow reports on a monthly basis. They’re often free, but you are obviously limited in access to once every 30 days.
What the flows can tell you
If you keep a keen eye on fund flow data, you can begin to spot some trends in the market, such as rotations out of higher growth stocks and into more value-like names, or vice versa.
When we look to two popular US funds, the Vanguard Growth ETF (VUG) and the Vanguard Value ETF (VTV), we can see that over the last year, the Vanguard Growth ETF has commanded the lion’s share of inflows. However, over the last month or so, there has been a surge in inflows towards VTV, the value-based ETF.
When we look to the overall market returns this year, the underlying numbers certainly confirm the flows. While the NASDAQ is down 4%~, the best-performing index in North America has been the Dow Jones, often filled with slower-growing names that tend to trade at attractive valuations during speculative market environments like we’re in right now.
Do you hold the right ETF?
With the amount of ETFs available today, plus the new issuances we’re seeing on a daily basis, it can be pretty tough to know if we’re holding the right funds.
With the pace of new ETFs hitting the market, what we bought even a month ago may not be the best option today.
This is another element that fund flows can really help us navigate and make life a whole lot easier.
Let’s focus on one of the most rapidly developing ETF spaces for this example, the crypto space.
For the longest time, the best fund to hold here in Canada was often Purpose’s Bitcoin ETF, trading under the ticker BTCC.
For investors in the United States, it was often the Grayscale Bitcoin Trust, trading under the ticker GBTC.
If you ever had any questions as to whether or not you held the right Bitcoin ETF, they’d be solved relatively easily by hopping onto our screener and looking at the flows.
The creation of the iShares Bitcoin ETF (IBIT) south of the border has caused substantial outflows out of GBTC, to the tune of $16.5B over the last year.
For the Canadian exposure, Purpose’s funds have witnessed outflows of $729M.
Now, before you think, “Oh, well, that’s not too bad for Purpose,” just know that that $729M represented more than 25% of its entire assets under management.
For Grayscale’s GBTC? It was over half of the fund’s AUM.
These types of numbers are expected. IBIT had rock-bottom fees, and in a couple of clicks of a button (tax implications aside), investors could be saving upwards of 1% per year on fees.
Obviously, everyone’s individual situation is different. There could be a multitude of circumstances where owning a particular fund is better for your personal situation. However, large outflows from a fund can often mean there are better options.
Confirming investing ideas
Although you should never be utilizing fund flows to confirm a thesis outright, they certainly can be used to evaluate investing thoughts regarding particular asset or sector allocations.
One of the most significant examples I can use in this regard is international equities, whether it be emerging or developed markets.
International markets and investing in them is one of the most difficult decisions investors have to make. For one, they don’t understand the markets all that much. This makes sense. It is hard enough to navigate the North American market, let alone expanding out to global indexes.
Secondly, international markets have lagged the returns of North American indexes, and as such, investors continually second guess whether they even need exposure to them period.
Fund flows can help guide you in this regard. If you’re looking for exposure to a particular country or region, looking at flows into particular funds can really narrow down your shortlist in just a few minutes.
For example, utilizing our ETF screener, an investor could type “Japan” into the fund name filter and would immediately get 30 ETFs that focus on Japan. From there, one could sort the fund flows to see which funds are taking in the most capital and which funds are seeing outflows. This can narrow your search down to a select few funds instead of having to sift through dozens and being overwhelmed.
When fund flows can be a bit misleading
If we’re looking to utilize fund flows in our investing strategy, we must know that they come with limitations.
For one, there is a bit of randomness to it. Large outflows from an ETF can be nothing more than a large institution rebalancing its total allocations.
A prime example of this would be an all-in-one fund here in Canada rebalancing and shedding a lot of its equity ETFs and transitioning them to fixed income. This isn’t based on any sort of sentiment shift, but more so just a tactical move by the fund based on its rebalancing criteria.
Additionally, although this isn’t necessarily a misleading element of fund flows but one that requires an investor to do a bit more digging, is fund flows on an absolute basis don’t tell us much. We need to compare the fund’s assets under management relative to its overall flows.
An example of this would be 2 funds, one worth $500M and the other worth $100B. If both of these funds get $1B in inflows, it is obviously a material event for the fund with $500M in AUM, whereas it is just a routine event for the fund with $100B.
An interesting case study on ETF flows
Back in 2020, a few professors from Arizona, Colorado, and Utah got together to run some backtests on the activity of ETF flows.
Long story short, they found that there was an inverse relationship to the flows of an ETF and their subsequent returns.
Effectively, what they found out was that the funds with large inflows tended to underperform moving forward, while the funds with low inflows or potentially even outflows tended to outperform moving forward.
In a way, this makes sense. The higher the valuation we pay for assets, the lower we can expect our future expected returns to be. Buying the S&P 500 at all-time high valuations, which is what a lot of investors are doing judging by the inflows into the ETFs, will ultimately yield lower future returns than it would have if you bought it in 2022 when everyone was scared to touch it.
So, what are the fund flows telling us right now?
There is no question that the funds that top the list of overall inflows right now would be the S&P 500. However, this is often going to be the case, as this is the largest index in North America.
However, the pace of inflows is certainly one to keep an eye on. Recency bias has caused interest in the S&P 500 to surge, and we’re seeing a large amount of retail investors flowing into the funds, thinking there really isn’t a point to owning anything else.
When we look to the S&P 500 right now, the price-to-earnings ratio of the index has increased by 25%~ over the last year. This means that demand for the index and the companies within it has far outpaced the actual earnings growth of those companies.
Historically, when S&P 500 valuations get this high, it is an indicator of lower-than-average returns moving forward. Does that mean the index is set to crash? Not necessarily. However, larger-than-average interest in the index is no doubt bloating valuations at this point.
On the flip side, energy is seeing large-scale outflows
Crude oil has managed to maintain prices around $70 a barrel, and natural gas is soaring in price. Yet, when I head to my ETF screener and search for energy funds, I get around 80 of them, with 60 of them having net outflows over the last year.
It is hard to imagine sentiment more bearish in the energy sector at this point in time.
XEG, which is the iShares S&P/TSX Capped Energy ETF, is witnessing the lowest levels of interest since the fund’s inception 25 years ago.
To me, a quick look at the outflows in energy ETFs leads me to believe there is too much negative sentiment in this sector. While money literally floods into US growth equities, these large companies are trading at rock-bottom valuations and still producing significant amounts of cash flow.
Despite growing revenue by 15% over the last year and earnings by 11%, the companies in XEG are trading, on average, at 5 times free cash flow.
There are likely worries here that a recession would push down the demand for oil and natural gas. However, I think a large chunk of that is priced-in at this point anyway. With the future demand for LNG and the slower shift to renewables, there are a lot of high-quality energy funds that are trading at what I feel are large discounts.
Overall, fund flows are just another tool to add to our arsenal
I frequently utilize the fund flow area of my ETF screener to identify possible trends. Whenever a question pops into my head that can be answered by asking, “Where is the money going?” I’ll often whip over to the screener, filter out a select list of funds I want to study, and see where the money is flowing to.
Flows don’t tell us everything, but if utilized correctly, they can sure tell us a lot.
Whether we want to confirm if we own the best ETF in a particular segment today or if we’re looking to see if our potential contrarian views on a particular sector are supported by fund flows, the screener is a great resource.
What the screener has told me over the last 5-6 months is that there is some euphoria when it comes to US equities, particularly large-cap ones listed in the S&P 500.
Does that mean I’m selling all of my US holdings? Absolutely not. However, have I been a bit more cautious in purchasing them? Yes. In fact, I’ve built up one of the larger cash positions in my portfolio than I can remember in the last while.
Next week I’ll be producing some new fund reports for you to go along with updates on the funds we have available now.
As always, the Q&A is a great resource for members to get their questions answered
Whether it be on this month’s newsletter, an individual ETF, or even an investing strategy, our Q&A is an outstanding resource to get your questions answered. In addition to this, there is a huge database of existing questions that you can read over to build knowledge and potentially identify new opportunities.
