FFI Special Report: Bond markets floating on central bank liquidity attract risk-averse investors to fixed income funds ______

Edward Glyn, Head of Global Markets

Inflows to fixed income funds were almost equal to all other fund categories combined in August, as investors continued to shun riskier assets, according to the latest Fund Flow Index from Calastone, the largest global funds network. Net inflows to bond funds were £454m out of the total across all fund categories of £920m. This was the fifth month in a row that has seen bond-fund inflows well above the long run average, generating an FFI: Bonds of 55.9, well above the neutral 50 mark where the value of buy orders equals sells. Even so, year-to-date, strong inflows into fixed income in nearly every month have barely compensated for the enormous £3.6bn that flooded out in March when the bond markets seized up at the beginning of the Covid-19 crisis.

After two months of outflows, equity funds were spared further investor selling in August. Investors added just £74m to their holdings, however, only one sixth of the long-run monthly average. The winning categories were active global funds, almost half of whose £580m inflow was driven by purchases of ESG funds, and crucially a turnaround for European funds, driven mainly by purchases of index funds.  European funds enjoyed £170m of net inflows, the first time in two years that investors have added new money to funds specialising in European shares. These funds have accumulated outflows of over £5bn since the summer of 2018, however, so there is still a long way to go to recoup lost ground. UK equities were again among the categories to see the biggest shedding of capital, though the speed of the outflow has slowed. £195m left the category in August, making the £1.2bn in capital that has left since June the worst three-month period for funds investing in UK equities on Calastone’s record. Equity income funds continued to see strong outflows too.

In total, equity index funds continued to beat their active counterparts in August, gathering £318m of new capital in contrast to outflows of £244m from index funds. Passive funds have now beaten active funds in 24 of the last 26 months.

Overall trading volumes across all fund types were unusually low in August, even allowing for seasonal patterns. Turnover dropped by almost a third month-on-month, much more than the 5-10% decline Calastone usually sees flowing across its network during the holiday season. Bond and equity funds saw the biggest drops in activity, while mixed assets remained characteristically more stable.

Edward Glyn,  head of global markets at Calastone said, “Implied volatility in the bond markets as measured by the Move Index is near record lows as bond markets are calmed by central bank stimulus. This calm is attracting investors. Meanwhile, the Vix ‘fear’ index suggests huge implied volatility for equities in the months ahead and that is dampening investor enthusiasm for equity funds.

Even so, fixed income is not quite the risk-off trade it used to be, though bonds of course still come with greater certainty than equities, at least if they are held for their full term. With interest rates near or even below zero on the most creditworthy bonds, there is little or no income to be had, so most of the returns from bonds are coming in the form of capital gains as falling rate expectations have pushed up prices. Changing perceptions of credit risk can also push prices up or down, particularly for bonds with lower credit ratings. The hunt for yield is driving bond investors into these riskier categories.

On the face of it, the inflow to European funds seems strange given rising infection rates but European equities are relatively cheap compared to their record-priced US counterparts and the dollar is in decline. Funds focused on US equities had one of their worst months in the last year in August so investors may be switching focus as a hedge against the political, social and economic upheaval in the US, though we will need to see several more months of solid inflows to Europe before we can be sure this is a new trend. Low valuation alone is not enough to tempt investors as unloved UK equity funds can testify.

Financial markets have been exceptionally calm in recent weeks after a year of extreme volatility, so it seems that investors have taken a breather, perhaps steeling themselves for a very eventful final quarter bringing the US election, the northern hemisphere winter and its risk of a resurgent pandemic, as well as greater clarity on the extent of the economic damage caused by the outbreak.”

Methodology

Calastone analysed over a million buy and sell orders every month from January 2015, tracking monies from IFAs, platforms and institutions as they flow into and out of investment funds. Data is collected until the close of business on the last day of each month. A single order is usually the aggregated value of a number of trades from underlying investors passed for example from a platform via Calastone to the fund manager. In reality, therefore, the index is analysing the impact of many millions of investor decisions each month.

More than two thirds of UK fund flows by value pass across the Calastone network each month. All these trades are included in the FFI. To avoid double-counting, however, the team has excluded deals that represent transactions where funds of funds are buying those funds that comprise the portfolio. Totals are scaled up for Calastone’s market share.

A reading of 50 indicates that new money investors put into funds equals the value of redemptions (or sales) from funds. A reading of 100 would mean all activity was buying; a reading of 0 would mean all activity was selling. In other words, £1m of net inflows will score more highly if there is no selling activity, than it would if £1m was merely a small difference between a large amount of buying and a similarly large amount of selling.

Calastone’s main FFI All Assets considers transactions only by UK-based investors, placing orders for funds domiciled in the UK. The majority of this capital is from retail investors. Calastone also measures the flow of funds from UK-based investors to offshore-domiciled funds. Most of these are domiciled in Ireland and Luxembourg. This is overwhelmingly capital from institutions; the larger size of retail transactions in offshore funds suggests the underlying investors are higher net worth individuals.