Portfolio Flows’ Historic 15-Year Itch

The April IMF Global Financial Stability Report draws a mixed record in a 15-year rendering of bond and stock allocation from altered global and local investor bases, as it applauds new asset classes substituting for cross-border banking decline which may stoke herding and volatility. Retail selloffs the past year have raised questions about external shock exposure despite the transfer of exchange rate risk and better economic fundamentals. Integration may heighten capital flow sensitivity across the range of business, household and sovereign borrowers and fixed-income is more correlated to “push” factors than equities, according to the analysis which derives from a proprietary custodian database and other official and private institutional sources. General mutual funds are less stable and recipient markets can mitigate the fallout by deepening domestic banking and securities scope especially in debt holding where foreign participation is high. However the vehicles under this category defy common structure and strategy and include open/closed end, active-passive, cross-over and dedicated ones. Since the gross flow quintupling over the past decade and a half hundreds of funds have been tracked by EPFR and other industry references. Equities were the original rage in the 1990s and gave way first to external sovereign then local and corporate bonds that now dominate. The Fund finds that institutional investors universally have hiked allocation in recent years, with particular preferences. Pension sponsors have diversified into local-currency instruments; 40 percent of insurance executives interviewed plan increases in EMEA stocks and corporate bonds; central bank reserve managers with $10 trillion concentrate on a half dozen large destinations and sovereign wealth funds favor the BRICs. Boom-bust cycles for shares have been more globally synchronized than for fixed-income but the trend there too has risen during the “turbulent times” since 2012, the study comments.

The latter is more closely tied to the VIX, and mutual funds tend to engage in return-chasing, pro-cyclical behavior. Momentum trading is also typical among big institutions during ratings downgrades and especially loss of prime-quality status. Hedge funds have displayed uneven approaches as leveraged ones which account for half of the universe pulled back in 2008 but stayed the course in 2013 as “contrarians” smoothing fluctuations. Open-end and active ETFs are most tied to global financial conditions and geographic location is also important as US, European and Japanese versions show different VIX relationships. Less involvement by offshore domiciles may cushion swings, and reduced global bank market-making under regulatory strictures may cramp liquidity and propel yields in lockstep. The report recommends that the governance and infrastructure elements of financial system modernization take priority over growth and market-building. The rule of law, accounting and auditing standards, and government policy transparency can have “larger impact,” although bond market initiatives such as the G20 action plan have been limited so far. The information gap around large investors remains outstanding and backup credit lines and reserves will be vital until the knowledge can be scratched, it adds.