A strategy for times when the flow needle is stuck
The COVID-19 pandemic, a resurgence of Sino US trade tensions and protests against police brutality in the US have not stopped global equity markets from zigzagging higher.
From a mutual fund perspective, the correlation between equity fund flows to and from developed markets and benchmark performance remains relatively stable – 38.4% YTD -- and recent inflows are pushing the markets back to where it was four months ago (See Chart 1 below).
Chart 1 – DM Fund Flows vs Benchmark
Things are less ‘straightforward’ in the emerging markets universe, so much so that the opportunities to extract alpha from recent trends looks like an uphill struggle. But one of EPFR’s older strategies may provide they key.
Coming into June EPFR-tracked funds collectively pulled money out of emerging markets for the 16th consecutive week (Chart 2). Meanwhile, widely tracked EM equity benchmarks have been recovering since mid-March.
Chart 2 – EM Fund Flows vs Benchmark
This contradictory behavior poses a challenge for investors, who are trying to reconcile consistently negative flows with the almost 20% gain racked up by the benchmark during the current recovery phase.
One thing that is clear is that active managers are still in wait-and-see mode when it comes to both emerging and developed markets. As charts 3 & 4 illustrate, the clearest signal is the selling of emerging markets equity by passively managed funds, which have liquidated $28.3 billion, or 5.6% of their total EM assets under management, since the beginning of April.
Chart 3 – DM flows: active vs passive
Chart 4 – EM flows: active vs passive
Putting a thumb of the right side of the scales
Under these circumstances, a time-series momentum strategy will lose money if we follow either trend. However, dusting off EPFR’s EM vs DM indicator -- discussed in an earlier Quants Corner post -- can help to generate alpha.
In simple terms, the indicator suggests overweighting exposure to EM or DM equity based on which of those two asset classes has received the bigger flows (or had the smaller outflows) as percentage of AuM (see chart below).
With Active EM, Active DM and Passive DM flows currently showing little conviction, the sustained Passive EM outflows keep the indicator pointing to DMs.
Investors who acted on that signal made money. Since mid-March developed markets have a 5% edge in performance over emerging markets.
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