The Big Idea

Fund flows, momentum and relative value

| March 8, 2024

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The Main Street total return crowd is enjoying a bit of a good stretch this year, at least if you are counting assets. Taxable mutual funds and ETFs in the first two months have taken in a net of nearly $96 billion, some of their biggest hauls in more than two years. The surprising winners have been actively managed funds after years of losing to ETFs. The strong inflows in general should add momentum to debt returns, and the flows to active hands should bring a little more policing of relative value to the market. The best strategy for capitalizing on the flows: sell your losers, and let your winners run.

A generally strong start

Taxable funds and ETFs added $49 billion of AUM in January and $47 billion in February, according to the Investment Company Institute (Exhibit 1). Those flows contrast sharply with average monthly inflows in 2023 of $14 billion and average monthly outflows in 2022 of $19 billion.

Exhibit 1: AUM at bond mutual funds and ETFs has jumped this year

Source: Investment Company Institute, Santander US Capital Markets

The surge in flows almost certainly reflects the strong returns to public debt since the Fed pivoted on November 1. Between then and the end of the year, the Bloomberg US Aggregate Bond Market Index returned nearly 7.5%. Taxable flows usually follow the trailing returns of the aggregate debt markets, with inflows following market rallies and outflows following sell-offs. In 2022, the worst returns in the history of the index (-13%) brought heavy outflows. In early 2023, better returns brought inflows. And weak returns in mid-2023 triggered brief outflows again.

The latest inflows also have likely contributed to the tightening of spreads in credit and MBS so far this year. Since inflows and outflows usually trail performance, they arguably give performance a certain amount of momentum. Investors chasing good returns bid up the marginal price of assets further, and investors fleeing bad returns push marginal prices down.

Mutual funds take in the most AUM

The biggest winners in this year’s surge have been actively managed mutual funds instead of ETFs. Inflows to taxable mutual funds topped ETFs by a slight $3.3 billion in January and then blew past them by $26.4 billion in February (Exhibit 2).

Exhibit 2: Taxable mutual funds have outpaced ETFs in drawing funds this year

Source: Investment Company Institute, Santander US Capital Markets

In fact, most of the ups and downs in aggregate flows to taxable funds come from mutual funds rather than ETFs. Since early 2022, mutual funds have lost an average of $13 billion in AUM a month with a standard deviation of $24 billion. ETFs, meanwhile, have kept piling up AUM with an average monthly gain of $15 billion and a standard deviation of $8 billion—only a third of the AUM volatility of their mutual fund competition.

An important part of the AUM volatility of mutual funds comes from the heavier share of those funds held by retail rather than institutional investors. Retail investors tend to sell in down markets and buy in up markets. ETFs attract a larger share of institutional investors, including some mutual funds that hold ETFs as an efficient way to hold an index-neutral position while waiting for relative value opportunities. Institutional Investors are more likely to hold through ups and downs, creating the relative stability of ETF AUM. For now, mutual funds are benefiting from their larger retail base.

The flows to mutual funds should help police relative value to the extent that funds diverge from index weighting of assets. The steady growth of ETFs has put pressure on mutual funds to either show returns in excess of market indexes or cut fees to the same level as ETFs. Active managers usually opt for the excess return route, and that requires decisions about being over- or underweight different sectors and about security selection within sectors. That should encourage more relative value trading on the margin.

The inflows to mutual funds should also help their managers stay more fully invested than in markets where outflows look likely. Mutual funds usually hold some small amount of cash to fund redemptions, although returns on cash can serve as a drag on fund performance—although possibly not as much now with an inverted yield curve. Inflows can fund redemptions and allow fund managers to hold less cash.

Sell your losers, let your winners run

In markets where retail money is either chasing or fleeing recent returns and swinging mutual fund AUM, investors that want to capitalize on those flows should sell their losers and let their winners run. Of course, that strategy should get modified based on what the Fed, banks, insurers and others are doing along with changes to the fundamental risks of assets. Nevertheless, positions that have not worked out so far this year should see the exit and get reinvested in an index-neutral allocation. As for the winners, well, you know what to do.

* * *

The view in rates

Fed funds futures reflect at least three cuts by December and an 80% chance of a fourth cut that month. That will not happen if Stephen Stanley is right and the Fed stays on hold through the November US elections. Whether the market or Stanley wins will likely depend on the path of inflation into July. If it is down significantly, which seems unlikely, the Fed could start cutting at that month’s meeting. If not, the Fed likely waits for politics to settle. Implied rate volatility remains elevated, although at local lows.

Other key market levels:

  • Fed RRP balances closed Friday at $444 billion, up a paltry $4 billion week-over-week but part of a steady trend down since April. Treasury bills and Treasury and MBS repo almost all trade at yields above the RRP’s 5.30% rate, giving money market funds good reason to move cash out of the RRP and into these higher-yielding alternatives.
  • Setting on 3-month term SOFR traded Friday at 532 bp, down 1 bp week-over-week.
  • Further out the curve, the 2-year note closed Friday near 4.47%, down 6 bp in the last week. The 10-year note closed at 4.07%, down 11 bp in the last week.
  • The Treasury yield curve closed Friday afternoon with 2s10s at -40, flatter by 5 bp In the last week. The 5s30s closed Friday at 21 bp, steeper by 4 bp over the same period.
  • Breakeven 10-year inflation traded Friday at 228 bp, lower by 4 bp over the last week. The 10-year real rate finished the week at 179 bp, up by 13 bp in the last two weeks.

The view in spreads

Credit has momentum and a strong bid from insurers and mutual funds, the former often funded with annuities and the later getting strong inflows. Liquidity is likely to trend lower through 2024 as QT and relatively high rates in the front end of the curve continue to soak up cash. Lower liquidity is likely to keep volatility elevated, keeping pressure on spreads, leaving them a tad wider than otherwise. Nevertheless, spreads should trade stable to tighter for the foreseeable future. The fact that markets have now priced to the Fed dots also looks bullish for credit spreads.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 96 bp, tighter by 1 bp over the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 145 bp, tighter by 10 bp in the last week. Par 30-year MBS TOAS closed Friday at 36 bp, tighter by 11 bp over the last week. Both nominal and option-adjusted spreads on MBS look rich. Fair value in MBS is likely closer to 70 bp, so a widening toward 70 bp looks reasonable.

The view in credit

Most investment grade corporate and most consumer sheets look relatively well protected against higher interest rates, and eventual Fed easing—even late this year—should relieve pressure from interest rate expense and falling liquidity. Fixed-rate funding has large blunted the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. Consumer balance sheets also benefit from record levels of home equity and steady gains in real income. Consumer delinquencies show no clear signs of stress. Less than 7% of investment grade debt matures in 2024, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
1 (646) 776-7864

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

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