Fund Flows reflect the net of all cash inflows and outflows from a mutual fund or ETF. This means that fund flows do not consider the change of performance from the fund or the assets from the fund. However, a positive fund flow can be interpreted as excess cash for fund managers to invest, which would potentially increase the purchase of assets from the fund.

Fund Flows=fund cash inflows – fund cash outflows

Example: A UK-domiciled investor wants an exposure to emerging markets sovereign debt but wants to diversify by investing in different EM sovereign debt. After some research, he decides to invest £10,000 in a UK-domiciled mutual fund focused on emerging sovereign debt. As a result, the £10,000 would become a fund cash inflow and, if everything stays the same, would reflect a positive fund flow for the mutual fund.

Flow of funds accounts are a system of interrelated balance sheets for a nation, calculated periodically. It is an extensive and reliable source to understand the financial status from specific sectors of the economy such as the government, households, businesses, and financial institutions. For example, we can quantify the level of liquidity risk of the pension fund sector by analyzing its assets and liabilities data provided by the flow of funds. Normally, the government of a particular country publishes the flow of funds quarterly. In the report, there are two types of balance sheets:

• The aggregate assets and liabilities for financial and nonfinancial sectors.
• What sectors issue and hold financial assets (instruments) of a given type.

Portfolio flows are cross-border transactions in financial assets: flows of money and assets across borders. If a UK investor buys bonds or equities from a US holder, that’s a portfolio flows.

Portfolio assets are things like bonds and equities. Economists use the phrase portfolio flows specifically to mean the cross-border flows, and these they record in the balance of payments.

Capital flows: this term covers all the cross-border transactions, not only the portfolio flows, but foreign direct investment (e.g. when a controlling interest, not just a share in something, is traded) and other investment flows – the (foreign) capital which flows into banks and other financial institutions.

To read a technical document from the IMF on tracking capital flows, click here

Liquidity: The term liquidity is used to indicate how fast can an investor buy or sell a particular asset. The higher the liquidity, the better it is for investors as they have the flexibility to move in or out of an asset depending on the status of economic factors, asset-specific factors, or investor’s sentiment. Liquidity is particularly important in periods of recessions and market corrections since asset prices usually decline significantly in a short period of time. Investors who have low liquidity assets in these periods may be unable to sell the assets in time, resulting in great losses in their portfolio. However, some investors may become attracted to illiquid assets if they offer higher returns than liquid assets.

Fund allocations: the asset allocations of mutual funds and ETFs at a point in time are a form of positioning data. If the weighted average allocation of a large group of foreign-domiciled asset management companies’ dedicated emerging market debt funds to South African government debt is below the weight of South Africa in the benchmark index those funds follow, then we say directly that that group is underweight. It might be that, if we see large bond portfolio outflows from South Africa, that that group is reducing allocations to South Africa, but there might be another explanation, for example selling by funds not dedicated to emerging market debt. Positioning data speaks more directly than flow data here.

Market structure: the composition of the holders of portfolio securities at a point in time are a form of positioning data. Different holders have different motivations and different constraints and these give rise to different behaviours. You can arrive at positioning by knowing about the different investors in a market (market structure) and how they are positioned (e.g. through their asset allocations).

The behaviour of foreign investors can a big impact on the price of bonds issued by emerging market sovereigns. If foreigners suddenly start to demand more bonds from Nigeria, Colombia, Romania, Sri Lanka, Pakistan, Egypt or the Ukraine, for example, prices can react strongly. This is not so much the case in larger EM bond markets like Brazil or Mexico.

The behavior of local investors can have a big impact on asset prices. Some markets have large local institutional investors bases, e.g. South Africa or Brazil. In these countries, local investors work as buffers of selloffs by foreign investors. On the contrary, markets, which are highly dependent on foreign investors, have a great risk of significant asset prices corrections due to capital outflows.

We calculate average allocations as the average of the sample of available data.

For example, if we find allocations to the Mexican Peso on 35 fund factsheets, then we report the average allocation as the mean of that sample.

The allocations themselves are reported as absolute percentages (for example 9.9% or 8.4%). Average allocations can be calculated for allocations to countries, currencies, duration, yield, cash and credit ratings.

Different definitions of the variables are used to calculate the averages (e.g. Average yield includes YTM, average yields, etc..). Credit ratings average allocations do not sum to 100% as funds often report their allocations in bands, whereas we calculate averages across specific credit ratings.

Since many funds only report their top 10 country allocations on their factsheets, this produces allocation data which has an upward selection bias as we are more likely to include a country’s allocation if it has a higher allocation. This is more pronounced for countries that have a lower weight in the benchmark.

We also calculate average allocations that assume that funds not reporting their allocation for a country have a zero allocation or the same allocation as the benchmark. The closer these values are together, the more confidence we have in the allocation.

Inferring positioning in risk factors from performance:

It is possible to “back out” or make inferences about positioning using price data (total return data). The performance of a fund – the total return over 1 (3, 5 and 10) year(s) – can be compared to the performance of the benchmark index.

If the fund has outperformed the index during a period when riskier assets outperformed less risky assets, then we can infer that the fund’s positioning was “risk-on”.

The fund must have been overweight the bonds which increased in value more than average – the riskier bonds – and underweight the bonds which increased in value less than average – the less risky bonds.

The World Government Bond Index (WGBI) measures the performance of fixed-rate, local currency, investment-grade sovereign bonds. Composed by more than 23 countries, the WGBI has minimum requirements to allow sovereign bonds into the index:

• The market of the sovereign bond must be easily accessible to foreign investors
• Coupon should be fixed with a minimum maturity of 1 year
• Market size of the sovereign bond should be a minimum of 50 billion USD
• Minimum credit of A- by S&P and A3 by Moody’s

WGBI serves as an important benchmark for passive and active global fund managers. In the case of passive funds, they directly adjust their portfolio by purchasing or selling bonds to replicate the portfolio allocation of the WGBI. Similarly, active funds are constantly compared to the WGBI as a benchmark and are expected to overperform. If an active fund performs equally or lower than the WGBI benchmark, then investors from the fund may decide to remove their capital from the active fund and invest in a passive fund with lower commission. As a result, many active fund managers control the risk of underperforming by having some degree of similarity to the WGBI portfolio allocation. The significant influence of the WGBI on active and passive managers causes massive correlation in capital inflows and outflows of emerging markets. This is known as “the index effect” – the phenomenon of abnormal trading volumes that are a consequence of either:

• Country exclusion or inclusion in the index or
• Change of a country’s weight in the index

When a new sovereign bond is included in the WGBI, benchmark-driven funds adjust their portfolio by using cash or selling assets to purchase the new sovereign bond. In the same manner, an increase of a sovereign bond’s weight in the WGBI causes benchmark-driven funds to sell other assets and purchase more of the sovereign bond. The magnitude of the “index effect” varies between markets. The more benchmark-driven funds in a market, the bigger the effect on asset prices.

Do Multi-Sector Bond Funds Pose Risks to Emerging Markets?

Author/Editor: Fabio Cortes, Luca Sanfilippo. (2020)
Series: IMF Working Paper 20/152 , Washington, DC.

Summary:

“Emerging economies in the post-crisis period increasingly saw portfolio debt inflows from a type of large international investment fund: Multi-Sector Bond Funds (MSBFs). These investors have lacked adequate representation in the literature. This paper constructs a new detailed database from micro-level MSBF emerging market (EM) holdings from 2009:Q4–2018:Q2. Exploiting this data, the paper assesses the risks they pose to the financial stability of specific emerging bond markets. The data shows that MSBFs are highly concentrated–both in their positions and their decision-making. The empirical results further suggest that MSBFs exhibit opportunistic behavior (and more so than other investment funds). In periods of high risk aversion, large MSBF portfolio reallocations out of EMs can be associated with underperformance of the same markets, signaling the importance of monitoring their footprint and better understanding their asset allocation decisions.”

Sovereign Risk and Mutual Fund Portfolios

Author/Editor: Converse, Nathan, and Enrico Mallucci (2019)
Series: International Finance Discussion Papers 1261.

Summary:

“The results are supportive of models of sovereign default that assign a nontrivial role to the preferences of international creditors.”

A Guide for Empirical Analysis and Real-time Tracking

Author/Editor: Robin Koepke; Simon Paetzold

Summary:

• A guide for academics who embark on empirical research projects and for policymakers who need timely information on capital flow developments to inform their decisions
• We address common misconceptions about capital flow data and discuss differences between high-frequency proxies for portfolio flows
• High-frequency proxies have significant predictive content for portfolio flows from the balance of payments (BoP)
• We also construct a new dataset for academic use, consisting of monthly portfolio flows broadly consistent with BoP data.

Emerging Market Portfolio Flows : The Role of Benchmark-Driven Investors

Author/Editor: Serkan Arslanalp and Takahiro Tsuda (2015)
Series: Working Paper No. 15/263

Summary:

“Portfolio flows to emerging markets (EMs) tend to be correlated. A possible explanation is the role global benchmarks play in allocating capital internationally, the so-called “benchmark effect.” This paper finds that benchmark-driven investors indeed play a large role in a key segment of the market—the EM local currency government bond market—, accounting for more than one third of total foreign holdings as of end-2014. We find that the prominence of these investors declined somewhat after the May 2013 taper tantrum, but remain high. This distinction is important in understanding the drivers of EM capital flows and their sensitivity to different types of shocks. In particular, a high share of benchmark-driven investors may result in capital flows that are more sensitive to global shocks and less sensitive to country factors.”

What Drivers Capital Flows to Emerging Markets? A Survey of the Empirical Literature

Author/Editor: Robin Koepke

Summary:

This paper reviews the rapidly growing empirical literature on the drivers of capital flows to emerging markets. The empirical evidence is structured based on the recognition that the drivers of capital flows vary over time and across different types of capital flows. The drivers are classified using the traditional “push vs. pull” framework, which is augmented by a distinction between cyclical and structural factors. Push factors are found to matter most for portfolio flows, somewhat less for banking flows, and least for FDI. Pull factors matter for all three components, but most for banking flows. A historical perspective suggests that the recent literature may have overemphasized the importance of cyclical factors at the expense of longer-term structural trends.

Benchmark-Driven Investments in Emerging Market Bond Markets – Taking Stock

Author/Editor: Serkan Arslanalp, Dimitris Drakopoulos, Rohit Goel, and Robin Koepke

Summary:

First, we provide an overview of how key EM bond benchmark indices are constructed, how they affect the behavior of investment funds, and what are the likely implications for capital flows dynamics. Second, we provide up-to-date estimates of the size of benchmark-driven investments in local EM bond markets, estimated at around $300 billion as of end 2019 before the COVID-19 shock in early 2020 (Figure 2). Third, we provide empirical results demonstrating the heightened sensitivity of benchmark-driven investments to external factors, which leads to an elevated correlation of such flows across countries.

The Global Capital Allocation Project  

Plenty of investors describe their behaviour as *trend following*, which means they follow the trend in prices. Trend following strategies can also be formulated using flows data.

For example, be bullish / overweight / positive emerging market sovereign debt if there is a trend of inflows to the asset class, and vice versa. Observe fund flows data to see if end-investors are putting money into EMD funds. Observe portfolio flows data to see if developed markets residents are net buyers of EMD from emerging markets.

In the contrarian strategy, investors short (or go underweight) the crowded trades, and overweight the unpopular trades. Use positioning data to identify what positioning looks like, and take the contrarian view.

Here’s the story of the mechanism of how positioning causes asymmetric responses in price. There are four cases.

1. If the positioning is ‘short’ or underweight, and the news is good, there is a ‘short squeeze’ as many participants try to enter through a narrow door, and prices rise strongly.
2. If the positioning is ‘long’ or overweight, and the news is good, there is no such short squeeze. Prices still rise, but significantly less so.
3. If the positioning is ‘long’ or overweight and the news is bad, there is a disorderly pullback as many participants try to exit through a narrow door, and prices fall strongly.
4. Finally, if the positioning is ‘short’ or underweight and the news is bad, there is no disorderly exit. Prices still fall, but less significantly.

The field of economics should be expanded to include serious quantitative study of changing popular narratives. We cannot easily prove that any association between changing narratives and economic outcomes is not all reverse causality, from the outcomes to the narratives. But there have been true controlled experiments showing that people respond strongly to narratives.

Most speculative asset prices are nearly random walks on a day-to-day basis. The reason is obvious: if it were possible for smart money to predict the day-to-day price changes even reasonably well, they could become rich very fast, and they would take over the market. In a bubble, the contagion is altered by the public attention to price increases: rapid price increases boost the contagion rate of popular stories justifying that increase, heightening demand and more price increases.

Robert Shiller, Presidential address delivered at the 129th annual meeting of the American Economic Association, January 7, 2017

• Argentina sold USD 2.75 billion of a hotly demanded 100-year bond in U.S. dollars on Monday, just over a year after emerging from its latest default.― 20 Jun 2017
• Argentina’s century bond caught in dash for exit ― Financial Times, 26 April 2019

• A mutual fund is a type of investment vehicle consisting of a portfolio of stocks, bonds, or other securities.
• Mutual funds give small or individual investors access to diversified, professionally managed portfolios at a low price.
• Mutual funds are divided into several kinds of categories, representing the kinds of securities they invest in, their investment objectives, and the type of returns they seek.
• Unlike stock, mutual fund shares do not give its holders any voting rights. A share of a mutual fund represents investments in many different stocks (or other securities) instead of just one holding.
• the price of a mutual fund share is referred to as the net asset value (NAV) per share
• A fund’s NAV is derived by dividing the total value of the securities in the portfolio by the total amount of shares outstanding.
• Outstanding shares are those held by all shareholders, institutional investors, and company officers or insiders.
• Mutual fund shares can typically be purchased or redeemed as needed at the fund’s current NAV, which—unlike a stock price—doesn’t fluctuate during market hours, but it is settled at the end of each trading day.

Q.    What is an ETF?

A.    An exchange-traded fund (ETF) is a pooled investment vehicle with shares that trade intraday on stock exchanges at a market-determined price.

Q.    So ETF’s are like shares?

A.    Yes, in that you may buy or sell them through a broker just like you would the sharesBut ETF’s are pooled investment vehicles. You are getting exposure to many securities, not one.

Q.    So ETF’s are like mutual funds?

A.    Yes, in that you get exposure to many securities, but no, because traditional mutual fund shares don’t trade on exchanges; you purchase or redeem directly.

A debt instrument is a financial claim that requires payment(s) of interest and/or principal by the debtor to the creditor at a date, or dates, in the future. Debt securities are negotiable financial instruments serving as evidence of a debt.

Now, we divide an economy into five sectors* that are resident in the economy.

So, when we’re talking about the debt of an economy, one way we’ll be talking about it is by which of the five types of sector is the issuer (the debtor).

The five sectors are:

• Nonfinancial corporations
• Financial corporations
• General government
• Households
• Nonprofits serving households

What about the Public and Private sectors?

Well, general government is obviously the public sector. But the public sector also includes those corporations controlled by the government. Then the private sector is everything else.

When we’re talking about the debt of an economy, a second way we’ll talk about it is by which currency the debt is denominated in. There are really just two types:

• the economy’s own currency: the local currency
• another currency: an external currency

People talking about debt issued by residents of emerging economies talk about hard currency to mean one of a small group of external currencies including the US dollar, Euro, Yen and Pound Sterling.

When we’re talking about the debt of an economy, the third way we’ll talk about it is by who the type and what the residency of the holder. It’s common to talk about the residency of the holder as having two types:

• domestic (local) holders: residents
• external (foreign) holders: non-residents

External Debt is the name for the debt liability of the whole of an economy, both the government (the public) sector, and the corporate and financial (the private) sector, with respect to the rest of the world (the external sector).

There is a common misperception that external debt is the name for debt denominated in an external currency. Better to call that external-currency debt.

To re-emphasise, external debt has a specific meaning in the Balance of Payment and International Investment Statistics: if a resident has a current liability to a nonresident that requires payments of principal and/or interest in the future, this liability represents a claim on the resources of the economy of the resident, and so is external debt of that economy. So when we are talking about market structure, then if we are thinking about debt markets and investor residence, we can use the term external debt. We should not use it to mean debt denominated in an external currency. Hence the term external-currency bond is reserved for the latter.

The external sector is the economy’s position to the rest of the world. Positions are really stock variables – the situation at a point in time – and we’re interested in one particular aspect – to do with financial instruments – of an economy’s position to the rest of the world. It’s the international investment position, or IIP, which essentially tells you about two things:

• the stock of ‘foreign’ financial instruments an economy’s residents own – these are assets
• the stock of ‘local’ financial instruments owned by residents of other economies – these are liabilities

Financial transactions between an economy’s residents and the rest of the world – i.e. transactions in equities and debt – are called capital flows, and when they occur they change the financial position between the economy and the rest of the world. They give rise to flow data, because we define flows data as the data arising when there’s a transaction in financial assets or liabilities. They are often broken down into four types:

• Residents could buy ‘foreign’ instruments – e.g. Mexican pension funds buy US government bonds from Canadian pension funds (which would be a bond portfolio inflow for Canada)
• Residents could sell ‘foreign’ instruments – e.g. Brazilian hedge funds sell Polish equities to Polish banks (which would be an equity portfolio outflow for Brazil)
• Residents could sell ‘local’ instruments – e.g. Danish banks sell Danish government bonds to South African insurance companies (which would be a bond portfolio inflow for Denmark)
• Residents could buy ‘local’ instruments – e.g. British banks buy UK Gilts from French asset managers (which would be a bond portfolio outflow for France)

These transactions are recorded in a countries’ financial account, which is part of a larger / broader set of accounts of transactions between an economy and the rest of the world called the Balance of Payments.

Sovereign debt default refers to when national governments default on their debt obligations. Like other types of debt, sovereign debt is a contractual obligation. A failure to meet this contractual obligation for scheduled interest and principal payments in full on the due dates provides one clear-cut example of a sovereign default*. Theoretical literature highlights a variety of factors that can trigger sovereign default and debt crises. On the one side, countries can be unwilling to repay their debt, based on an intertemporal optimization calculus. On the other side, countries can be unable to repay their debt because they are either insolvent or illiquid. Whether a sovereign is insolvent or not, depends on its stock of debt relative to its ability to pay, measured, for example, by GDP, exports, or government revenues. A sovereign is solvent, if the discounted value of future primary balances is greater or equal to the current public debt stock. Likewise, a country is solvent, if the discounted value of future trade balances exceeds the current stock of external debt*. Nevertheless, as government responses to financial distress can take many forms, sovereign defaults are often not so explicit. In some cases, we can conclude that, even without an actual interruption of debt service, a default has effectively occurred because actions by the sovereign result in economic losses by creditors*.

Data: the Bank of Canada (BoC) developed a comprehensive database of sovereign defaults that is posted on its website and updated in partnership with the Bank of England (BoE).

The foreign exchange (FX) reserves of an economy form part of the stock of ‘foreign’ financial instruments owned by an economy / the economy’s residents, and as such they form part of the assets side of the international investment position. They are a specific part: that part owned by the public sector (specifically, by the central bank or other monetary authority) owned not as an investment (to grow in value, and eventually be used for consumption) but held to be used as a policy instrument, generally as an instrument to manage the exchange rate.

Foreign exchange reserves are assets (usually financial assets, especially government bonds) denominated in foreign currencies held by an economy, generally by its central bank.

The balance of payments (BOP) is a statement of all transactions made between entities in one country and the rest of the world over a defined period of time, such as a quarter or a year.