Key findings
Market context – fund flows in a bear market
Fund flows – fixed income
Fund flows – equities
Spotlight on Asia
Spotlight on Luxembourg
Overview
Fixed Income
Equities
Investor attitudes to equity funds show some key regional differences, but exhibit similar motivation
Inflation and economic contagion are driving a bear market
In most of the world, Covid-19 is no longer having a severe health impact, but economic contagion is gathering pace. The combination of excess demand as economies have reopened, massive surplus liquidity courtesy of central banks, supply constraints borne both of Chinese shutdowns and reduced labour participation in much of the developed world, and a food and energy shock exacerbated by Russia’s attack on Ukraine have led to spiralling inflation almost everywhere, a squeeze on household incomes and rising fears for global growth. Stagnating economies or even outright recessions combined with inflation are impossible for policy to correct painlessly.
A bear market has ensued across a range of asset classes. Equity markets are down only a little more than bond markets, proving that the historically unusual correlation they have shown on the upside (related to central bank QE programmes) has tracked the downside too. The riskiest assets are taking the biggest hit, however. The most speculative, like cryptocurrencies, have clearly and logically been hurt the most, but higher bond yields and lower growth expectations have changed the dynamic within conventional asset classes like fixed income, equities and property too.
Fixed income – risk dispersion is back and is driving big changes in investor behaviour
In fixed income markets, yields have risen most for lower rated bonds across corporate and sovereign issuers. From a maturity perspective, short-dated debt has seen the highest increase in yields reflecting the expectation of higher policy rates aimed at squeezing out inflation – two-year US treasuries have moved the most, now offering 3.3%[1], up from 0.2% a year ago. But long bond yields have risen too. What’s more, the European sovereign debt markets are under stress again, with sharp widening of yield spreads between the riskiest borrowers like Italy and those considered the safest, like Germany. For fixed income investors this all means there is a greater dispersion of risk than there has been for a very long time as the sedation of quantitative easing policies is replaced by the caffeine hit of monetary tightening. Greater differentiation between risky and low risk bonds and between the long and short end of the yield curve is healthy, but the adjustment process that is bringing it about is a painful one.
Equity markets – risk aversion hits long-term growth plays as investors turn to cash-generative blue chips
For equity markets, higher short-term bond yields are associated with a rising risk of recession – indeed a recession may be necessary to squeeze out inflation – and this means lower growth for company profits. Meanwhile higher long-term bond yields hit stock prices by marking down the present value of future profits. Lower near-term profits and a diminished valuation of future ones both mean lower share prices, especially for companies where expectations for distant future profits are the key driver of today’s price, like smaller companies or the technology sector. By contrast, companies with strong cash flow and decent pricing power, or for those like the energy and mining groups that benefit from today’s sky-high prices for their commodities, are withstanding the declines in stock markets rather well. These companies tend to pay out large dividends too, meaning income is back in vogue as an investment theme.
Property has some defensive characteristics but is not immune
In the property market, rental income is a bit more bond-like because commercial tenants tend to have relatively long leases and will look to cut other costs before facing the upheaval of a move. As an asset-backed income investment it therefore looks relatively attractive in today’s environment. But it is not immune. Capital values are sensitive to rising interest rates and a severe recession would inevitably lead to stress among tenants in more cyclically exposed segments like retail or offices, in contrast to more stable segments like healthcare. Finding funds with the right mix of holdings, particularly those with desirable properties that have pricing power, is therefore an important consideration for investors.
Alternatives – wide variety of asset types mean very different impact
Among other asset classes, there is wide differentiation too. For example, within the alternatives sector, there are different fund flavours that all respond in their own way. Infrastructure funds, for example, can often offer relative inflation protection given the way contracts for roads or railways are written, whereas funds with complex derivatives strategies could easily see exceptionally large losses if they made the wrong bets, or large profits if they got it right.
The paradigm shift that has taken place in the world economy in the last few months means fund flows have changed sharply across all the major asset types.
[1] 16th June 2022
Fund flows – overview
Fixed income
Fixed income funds are a much smaller asset class than equities
Fixed income funds are the second-largest category after equities. But they nevertheless only account for just under one fifth (19%[1]) of fund assets under management globally. They are less represented among Asian investor holdings (10%) than in Europe (21%) and the Americas (20%). At the global level, equity funds by contrast make up almost half (47%) of assets under management.
The level of fund turnover – the value of buy orders plus the value of sell orders – roughly reflects the relative size of bonds funds compared to equities. Over the last three and a half years since we began tracking the data, turnover of fixed income funds on our network ($721 billion) has duly been almost exactly half the turnover in equity funds.
But net inflows to fixed income funds were very large – until 2022
The net flow figures tell a different story, however. Since the beginning of 2019, the net inflow to fixed income funds of $74.1bn has exceeded the $71.6bn inflow to equity funds, despite the barnstorming performance of equity markets between 2019 and the end of 2021. This is at least partly explained by the positive correlation between equity and fixed income markets during the quantitative easing phase of global monetary policy. Simply put, lower yields across all maturities push up asset prices of all kinds. There has likely also been some portfolio rebalancing in action. This seems especially true in Asia, where investors on our network were significant buyers, reflecting a progressive correction of their lower weighting to fixed income when compared to their European and American peers.
Fixed income funds have seen a big adjustment in 2022
In 2022, things have changed dramatically.
Fixed income funds have seen a net outflow of $9.7bn across our network between January and the end of May 2022, contrasting with a net inflow of $11.3bn in the same period in 2021. Every month so far this year has seen net outflows, with February and March seeing the fastest flight from the asset class. At the time of writing, June was shaping up to follow suit, though at more modest levels. At 45.7, our fixed income Fund Flow Index for January to May 2022 is at its lowest point for comparable periods between 2019 and today. Indeed until 2022 it had only once fallen below the neutral 50 mark where buys equal sells and that was during the exceptional market dislocation of March 2020 when lockdowns swept the world and threatened a credit crunch. (see methodology for more explanation of our index).
Consistent investor behaviour across different territories
Investors in all our territories have shown similar behaviour this year but to a varying degree. Asian investors have been most negative, accounting for just over half the year-to-date outflow, but Europeans have shown the biggest change in sentiment, reversing $3.5bn of purchases in the first five months of 2021 with $3.6bn of outflows in the first five months of this year. This group is especially sensitive to renewed dislocation in eurozone debt markets.
Shedding risk is the key motivator behind large outflows
The complexion of flows shows a clear preference for shedding risk. Approximately one third of the net outflow came from funds investing in riskier high yield sovereign or corporate bonds, roughly double their share of market capitalization. This reflects higher risk of defaults.
Investors from every region sold down their holdings in this category, but those in Asia were disproportionately negative. In addition, almost one tenth of the outflow came from funds focused on emerging market bonds. European investors were especially negative on emerging markets, though again, selling came from investors in every region. Perhaps counterintuitively, high yield bonds are less sensitive to rising market interest rates because they tend to have shorter maturities and higher coupons – this gives rise to a lower ‘duration’ which describes the balance of cash flows from a bond over time: more cash flow sooner means lower duration and therefore lower sensitivity to the time value of money.
The outflows from the high yield category have instead been driven by rising credit risk – high yield bonds are very sensitive to a deteriorating economic outlook as their issuers are less typically less resilient. Emerging markets also suffer under a strengthening dollar as it reduces their creditworthiness if they issue bonds in dollars. We have already seen Sri Lanka default on its debts this year and the IMF is in talks with several other countries. Meanwhile, of course, Russia has become uninvestable. Among investors in corporate fixed income we noted a marked preference for funds investing in shorter dated bonds which are lower risk. All these patterns confirm the risk-off trend.
[1] Source: IIFA worldwide open-ended funds, excludes funds of funds, includes ETFs; latest data available refers to values at 31/12/21
Bear market is driving ‘the big switch’ in equity funds, but not significant overall outflows
Of course, equities are the biggest category of assets under management. The latest data available from the International Investment Funds Association is always a few months behind but it shows that regulated equity funds around the world reached a value of $33.6 trillion at the end of December 2021. This was pretty much the peak of the market and with global stocks markets down by a fifth year-to-date, the value at the time of writing is approximately $27.5 trillion, roughly where it was in November 2020.
With such a large asset class and such poor performance, it is perhaps therefore surprising that outflows have not been greater in 2022 so far. By the end of May, outflows from equity funds on our network had reached $1.6bn, rising to $2.4bn by the middle of June. This certainly stands in stark contrast to the same period in 2021, which saw inflows of £28.7bn in the first five months of the year[1], which were exceptionally high by historic standards. Yet the total figure this year is nevertheless relatively modest given the extreme downturn in the equity markets.
There is, of course, a structural bias towards inflows over time that results from the millions of regular savings plans investors have baked into their monthly budgets and this helps limit outflows even in bad times. Even so, by comparison to fixed income funds the level of outflows was small and by comparison to previous periods of outflows too. At least so far. How investors react in the weeks and months ahead remains to be seen.
Notably, the net cash that left equity funds in the first five months of 2022 came on the back of relatively high transaction volumes, only slightly below record 2021 levels. High turnover with a relatively small net cash inflow or outflow indicates significant switching between different types of funds. This is certainly how investors have behaved in 2022.
Risk shedding is key in equity funds too
The big switch can broadly be characterized as risk-off trades, which is consistent with the patterns we have seen in fixed income funds. For example, funds focused on small and mid-cap companies saw outflows of $2.6bn between January and May 2022, having enjoyed inflows of $1.6bn in the same period of 2021. Our Fund Flow Index for small-cap funds registered just 40.2, its weakest reading on our record, indicating that the value of sell orders was 1.5x bigger than buy orders Specialist technology funds, a relatively small sector by assets under management, saw $651m of outflows and also generated their worst index reading on our record for the first five months of the year, registering just 44.6, compared to a very positive 56.2 in the same period of 2021. Other high risk funds like biotech also saw significant outflows.
From a geographical perspective, outflows from funds focused on North American equities reflected a switch away from the highly-valued, tech-heavy US stock market. Outflows from funds investing in China followed from the crushing effect of the zero-Covid policy on China’s economy, while significant outflows from UK-focused funds mostly reflected switching among UK-based investors who are heavily weighted in domestic equities from generalist UK equity funds to other categories like income and ESG (see below). To put this in context, UK investors sold down $3.6bn of UK-focused equity funds but across all kinds of equity funds taken together they only withdrew a net $454m – in other words evidence of a big switch.
Outflows from European equity funds were driven by local investors
Outflows from European equities were also largely a function of a local investor base with a large domestic bias in their asset allocation – out of $5.2bn of net outflows, half came from funds focused on Europe, one third North America and one fifth UK. But unlike their peers across the English Channel, European investors were more focused on reducing equity holdings outright rather than simply switching. With war raging on Europe’s eastern frontier, sentiment is being hit much harder across the continent than it is elsewhere.
Income funds enjoy a long-awaited moment in the sun
A number of categories saw inflows, however. The most interesting is the change in sentiment around income funds. This category has been out of favour with investors for years as tearaway technology stories dominated the global investment narrative, while more traditional industries delivering slow growth but lots of cash for investors went relatively unloved. In an inflationary environment, income is back as a theme. This is because income-generating stocks are ‘low duration’ assets whose value derives in large part from near-term cash flow, rather than more speculative assessment of future growth prospects. Higher discount rates (long bond yields) have much less impact on these companies. A secondary consideration is the in-built inflation hedge that many of these companies offer because they tend to be able to raise the prices for their goods in line with inflation – healthcare is an example. Meanwhile, oil producers and miners are enjoying soaring cash flow as the prices of their commodities rides high.
After three straight years of outflows totalling $13.6bn, net flows to income funds turned positive in January 2022 and have continued ever since – investors had added a net $2.0bn by the middle of June. Investors from almost every region had been net sellers of income funds in 2019, 2020 and 2021, but this year they have all been net buyers – almost. Australians have very modestly sold income funds year-to-date, but they are nevertheless joining their peers elsewhere in adopting the income theme. This is because they have been strong buyers of domestic Australian equities. Dominated by slow-growth, big dividend-paying banks and huge commodity companies, the Australian stock market is one big income fund at present. Indeed, BHP, the Australian mining group, will be the biggest dividend payer in the world in 2022, according to the Janus Henderson Global Dividend Index.
ESG funds have also benefited from the big switch
The popularity of ESG funds has grown exponentially in the last four years, with inflows of $309m in 2019 rising to $32.2bn in 2021. In 2022, wariness about equity markets overall will mean lower inflows, but there is a marked contrast to other types of equity fund. By the end of May, ESG equity funds had seen net inflows of $4.9bn, compared to outflows of $7.2bn for non-ESG funds. This took the cumulative net inflow since January 2019 to $48.2bn, more than double the $21.1bn for all other kinds of equity fund, despite ESG still being a tiny category. Over that same period, the total turnover for non-ESG equity funds on our network was five times larger than for ESG funds – small inflows on very high turnover for non-ESG contrast with large inflows on small turnover for ESG. It looks likely that ESG funds will remain in positive territory all year in 2022. Most ESG strategies are global in nature which accounts for the inflows we have seen to global funds – exclude ESG and those are negative too. Investors in all our territories except Europe have been adding to their ESG equity holdings this year.
ESG funds are not inherently any less risky than regular equities. The companies and sectors they avoid certainly produce more negative economic externalities, but these costs are typically socialised rather than borne by the companies themselves – climate change or worker exploitation are two examples. The growth profile or income generation of companies with good ESG credentials is likely to be quite similar to other kinds of companies, once sector differences are allowed for. It would therefore be a misrepresentation to suggest buying of ESG is part of the risk-off trade we are seeing across all asset classes. The key point is that ESG is coming from a very low base – assets under management remain a tiny fraction (less than 4%) of equity funds overall – and it is in a clear structural growth phase. That means there is a both a strong bias among investors towards buying and also a relatively small pool of assets that could suffer selling activity.
Australian investors have bought equity funds in 2022 – reflecting income bias of domestic stock market
Not all investors have been selling equity funds this year. Australian investors added a net $1.4bn to their equity holdings between January and May, though they turned net sellers in the first half June. They were neutral or negative on every major equity category except Australian domestic equities and ESG, however. As we explained above, the focus on domestic equities reflects the particular complexion of the local stock market while the preference for ESG is in line with investors elsewhere.
Asian investors were also net buyers of equities. Across all our Asian territories, investors added $2.1bn between January and May. See Spotlight on Asia section for more detail.
Other asset classes are adjusting according to their risk profiles
The forces driving trends in fixed income and equities are having the effects we would broadly expect to see them have for other kinds of asset too.
Sentiment towards property has improved, reflecting the perception that property is a safer bet in times of high inflation. As we outlined in our market context section above, this is not universally true. Economic and market conditions vary from region to region and from one property segment to another. And of course, each building is unique.
In Europe and the UK, investors are becoming more positive on property, having been decided net sellers in each of the last three years. European investors have begun very tentatively to add to their property holdings, though it would be going too far to characterize their modest purchases as indicating a firm trend towards inflows. Meanwhile those in the UK have yet to break an uninterrupted 44 months of consecutive outflows, but the redemption of capital has now slowed to a trickle. Australians remain net buyers of real estate funds.
Commodity funds are having a good year. They are a small category, but inflows were almost three times higher in the first five months of 2022 compared to the same period in 2021. Moreover, investors in all our regions were net buyers of commodities. This is consistent with the search for inflation hedges, or at least places to find some shelter, that we are seeing across a range of asset classes. By contrast alternatives, often higher risk assets, have seen outflows this year. Mixed asset funds, a large category that spreads investment across a range of asset classes have seen a sharp reduction in inflows, though they are still seeing inflows. Given that investors are currently keen to differentiate between different flavours of equity and fixed income, it makes sense they would reduce appetite for a big catch-all category. But because mixed assets are popular in regular savings plans, they have continued to attract inflows
Active funds are being hit harder by negative investor sentiment, though ESG is providing support for equities
Active equity funds fought back against the rise of the index funds in 2021. Over the whole year, active funds on our network garnered a net $40.3bn of new capital, more than three times the $12.5bn index funds enjoyed. The year before by contrast, active inflows were half the passive ones and the year before that (2019), active funds saw outflows of $12bn compared to $10bn inflows to index funds.
The turnaround for active equity funds has been driven by ESG. ESG assets tend to be actively managed because fund managers often implement their own ESG scoring systems and select companies that conform to them. Despite still being a tiny category compared to the wider equity funds market, ESG accounted for $6 in every $10 flowing into active equity funds in 2021, in what was a bumper year for equity funds overall.
In 2022’s rocky market conditions, active equity funds are again falling behind. Both active and index funds had seen outflows by the middle of June, but the former shed -$1.9bn and the latter just -$493m. But if the inflow to ESG equity funds was excluded, regular active funds would have seen redemptions of $5.0bn by mid-June 2022, compared to an outflow of $2.2bn from regular non-ESG passive funds. European investors were particularly big sellers of active funds.
Index ESG funds are gaining in popularity, but active ones still have the marketing edge. For the time being we think ESG will continue to support active fund inflows (or limit outflows).
For fixed income funds, we rarely see outflows from the (much smaller) passive category. Investors clearly leave regular savings plans that steadily invest into index funds relatively untouched. Active funds, by contrast, benefited significantly during the compression of yields and are now bearing the brunt of the renewed emergence of risk differentiation. In other words, investors more actively trade active funds.
[1] $33.4bn in January to June 2021
Investors in Asia have been much more positive on equity funds than those in Europe and the UK and also more positive than their Australian neighbours. Across all our Asian territories, investors added $2.1bn between January and May, though this was three quarters less than the $8.1bn they added in the same period in 2021.
Hong Kong residents were the main buyers, accounting for just over half the net inflow from the region ($1.1bn) between January and May. Hong Kong’s residents cut their net investment by half year-on-year, a much smaller reduction than the regional average. In common with investors elsewhere, they favoured equity income and ESG funds in particular, but they also added to their Asia-Pacific holdings for the first time in three years and broke trends with peers elsewhere by buying North American equities too. In each of these categories they showed a greater preference for actively managed funds. They were net sellers of index funds, especially the global category.
Singapore’s investors showed the biggest reduction in the new capital they added to equity funds, down from $4.5bn in the first five months of 2021 to just $307m between January and May 2022. Singapore’s investors were more negative on every major category of equity fund, either reducing their net purchases substantially (as with Asia-Pacific and ESG funds) or turning to outright sales (as with European and North American equity funds). Meanwhile, Taiwanese investors reduced net inflows by three fifths to $267m. They favoured ESG funds above all others, adding $536m to their ESG equity funds holdings while withdrawing $269m from non-ESG funds.
Asia’s investors were much more negative on fixed income funds. Investors in the region began to withdraw capital from fixed income funds in September 2021, but sales gathered pace dramatically in 2022 averaging $2 of outflows for every $1 of inflows over the first five months of the year. Collectively Asian investors withdrew $5.2bn between January and May, with outflows continuing in June. Hong Kong’s investors accounted for just over half the total, those in Hong Kong another third. Taiwanese and investors across the rest of the region made up the rest.
The collapse of China Evergrande has put the property market in China and Hong Kong under a cloud, but with open-ended property funds not especially popular in a region with many listed vehicles, it is hard for us to draw many conclusions. In Singapore, we are tracking modest outflows year-to-date.
Luxembourg’s preeminent position in the European funds market means it is the largest recipient of cross-border fund flows on our network. The diagram below shows total value of all buy and sell orders. It shows that investors based across the rest of Europe and in the UK are the most important customer base for Luxembourg’s funds but it’s clear that investors in all of Calastone’s territories are attracted to the region’s centre of excellence. By value, almost nine-tenths of the orders we settle in Luxembourg come from other countries. Moreover, one third of all the cross-border flows we have handled since the beginning of 2019 have had Luxembourg as their destination. Only Ireland comes close as a destination for overseas orders, mainly thanks to its close integration with the UK market across the Irish Sea.
Growth in cross-border flows to Luxembourg has been in line with overall volume growth for fund transactions across our whole network over the last three and a half years, indicating that Luxembourg is comfortably maintaining its market-leading position.
The net flows in 2022 have of course reflected the preferences of Luxembourg’s customer base. For example, almost two thirds ($6.3bn) of the outflow we saw from fixed income funds across our whole network between January and mid June came from funds domiciled in Luxembourg. Sellers based in Hong Kong were the biggest drivers of these outflows, but investors in Luxembourg and the rest of Europe as well as Taiwan, the US and the UK, were also significant net sellers of Luxembourg-domiciled fixed income funds.
FINAL REMARKS
Asset markets are exceptionally volatile at present. Periods of high volatility understandably dampen investor enthusiasm to add new capital to funds. It’s well worth remembering, however, that net fund flows show much greater variability than overall transaction volumes. Total buying and total selling are both very big numbers so a small change in one or other of those figures can drive a very large change in net flows. By the end of May, we had processed $263bn of buy and sell orders in equity funds alone. Selling activity had only risen 2.2% year-on-year, while buying had dropped by 17.8% – the result was a small net outflow of $2.9bn this year compared to a huge $52.8bn in flow last year. Fund flows are also small in the context of the trillions of dollars under management.
In other words, net fund flows happen at the margin. Certainly clear trends emerge either as long-term structural changes or as short-term cyclical preferences, and these can tell us a lot about investor sentiment, but most investors actually do nothing at all to react to events. It’s a cliché to say that investors should try to buy low and sell high, but since timing the market is almost impossible, just buying steadily over time is typically the best way for investors to grow wealth over the long term.
A word about methodology
We have analysed tens of millions of buy and sell orders from 2019 to the middle of June 2022 as they flow into and out of investment funds around the world. 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, our research tracks the impact of many hundreds of millions of investor decisions each month.
We have not adjusted our figures for our market share. This varies widely from one country to another, but is over 80% in some territories. Any figures that appear in this report therefore only refer to volumes that pass over our own network. With such precise and granular data, we are nevertheless confident that the picture we are painting is representative of wider market trends.
All figures refer to orders where they were placed, not where they were executed, unless otherwise stated, for example in the Spotlight section on Luxembourg. Some markets like Australia see very little cash flow offshore. Others, like Taiwan, see almost all of it settled elsewhere. In the UK, about 15% of transactions by value takes place in funds domiciled offshore.
All the figures in this report have been converted to US dollars, with the exchange rate calculated for each individual trade on the day it was settled. This ‘real-time’ conversion means there are no distortions introduced, for example, by using average exchange rates for any given period.
THE CALASTONE FUND FLOW INDEX
Our Fund Flow Index (FFI) is a ready reckoner for comparing the popularity of different types of fund with investors. It compares net fund flows to total trading activity so that a small value of buying does not score highly in a big, actively traded fund category, but is rated as significant in a smaller one. A neutral score of 50 means the value of buys equals the value of sells. A reading of 75, for example, means the value of buys is three times greater than the value of sells. The FFI is also useful for comparing fund flows from investors in countries with small populations with those with large ones, or in territories where Calasatone has a significant market presence v those where we are smaller.
