Fund Flows and the Positive Feedback Loop

One of the things people should understand about the effect that historical returns have on large-scale rotations, especially in the institutional sphere of investment management, is that the 3-year number trumps all.

It is the major performance measure that goes into the decision-making process (alongside risk-reward, valuation etc) when shifts of allocation are being considered.

Positive 3-year numbers for a given asset class make a plan look better, and so they get included more frequently and in higher weightings for proposals than do asset classes whose back-tested 3-year numbers act as a drag.

Now you might say “But that’s backwards! Wouldn’t you want to include more of what hasn’t worked for a forward-looking plan rather than more of what has already worked?”  By asking that question, you betray a lack of understanding in how the human mind works. On Wall Street, plans and proposed allocations are rarely about what will work – they are about closing sales by alluding to what has been working and should continue to.

And so as allocation plans are drawn up, on a go-forward basis, the new math looks like this:

BarCap Global Aggregate Bond Index 3-year performance: 4.97%

S&P 500 Total Return 3-year performance: 15.3%

The question is, do you really think professional managers are going to underweight stocks anymore now that the 3-year numbers look like this? This is how the positive feedback loop begins. We can talk about how it ends another time.

The psychological shift away from the 2008 mindset happens slowly at first – and then all at once.

If you’d like to see this writ large, here’s a piece of BAML research John Melloy sent out earlier on this past week’s fund flows:

Stat #1: SECOND-BIGGEST EQUITY INFLOW EVER — $22.2bn inflows ($13bn via ETF’s and $9bn via LO funds) wk ending Jan 9

Stat #2: BIGGEST EQUITY MUTUAL FUND INFLOW SINCE MARCH 2000 ($8.9bn)

Source: BofAML (compilation of Lipper/EPFR data)

The driver here is allocation. The shifts happening right now within the $60 trillion pool of investable assets are tectonic.