Are fools rushing into the most popular ETFs?

Research suggests investing against the grain can yield 'bankable' returns due to prevalence of 'dumb' retail money

Are fools rushing into the most popular ETFs?

The popularity of certain ETFs among investors offer a signal of what not to buy, with excess returns to be had from shorting those with the highest inflows and buying those with the highest outflows, according to research.

New academic findings suggest that the prevalence of "dumb" retail money contributes to the contrarian nature of ETF flows, which is particularly strong for leveraged funds, reported the Financial Times.

“ETFs with large inflows predictably earn lower future returns than ETFs with large outflows,” said Shaun William Davies, one of the authors of the study.

Read more: Why leveraged ETFs might be too hot for the average investor

Flows into and out of leveraged ETFs, which give investors increased short-term exposure to an underlying market like the S&P 500, are "always contrarian," Davies continued, saying that downward markets tend to come with a rise in long leveraged flows and vice versa.

“[Buyers] are betting against a shock and preventing stocks from getting to their fundamental value,” he said. “They are catching a falling knife.”

In a study by Davies and several co-authors titled “ETF Arbitrage, Non-Fundamental Demand, and Return Predictability,” they found a portfolio that is short high-flow ETFs and long low-flow ETFs generated an excess return of 1.1% to 2% per month for US equity ETFs over a nine-year sample period.

Inflows to and outflows from leveraged ETFs were found to have a similarly high predictive power in Davies' follow-up paper, “Speculation Sentiment.” A rise in net flows of one standard deviation was linked to a decline in broad market stock indices of 1.14% to 1.67% the following month.

Some people didn't find the results surprising.

Leveraged ETFs "are associated with less sophisticated investors" because more knowledgeable traders can obtain comparable exposures more cheaply and effectively, according to Vitali Kalesnik, director of research for Europe at Research Affiliates, a California-based investment firm.

Read more: Handle leveraged and inverse ETF sales with care, says IIROC

In general, the researchers are detecting "mean reversion,” according to Kalesnik. “The dumb money flows in. If these large flows are unrelated to fundamentals, then ultimately there is mean reversion.”

The authors contend that their findings are the result of "non-fundamental" demand, which they define as "beliefs that are uncorrelated with fundamental news" as well as "over and under-reaction to fundamental news," represented by ETF flows.

According to their argument, this non-fundamental demand "distorts asset prices away from fundamental values," causing an eventual correction.

Still, Davies said the ETFs themselves were not sinister in and of themselves. The trading mechanism that works behind the scenes to keep ETFs priced, at least in normal market conditions, provides a "really clean way to observe mispricing," the authors argued.

A fund's share price will increase above the value of its underlying holdings if there are significant net inflows into the fund.

At that point, arbitrageurs or "authorized participants" come into the picture by purchasing a collection of securities and exchanging them for newly issued ETF shares with the ETF's provider. The shares are then sold by the AP, locking in the price difference, and bringing the price of the ETF and its underlying assets back into balance.

“Any time we see arbitrageurs or APs step in to create or redeem shares we know that either the share price or the underlying assets are experiencing excess demand,” Davies said.

The authors’ number-crunching indicates ETF share creations portend sub-market returns in the next months, as the mispricing effect from non-fundamental demand ebbs. The reverse also holds true, with redemptions tending to herald above-market returns.

“That suggests that ETF shares are relatively more sensitive to non-fundamental demand shocks than the underlying is,” said Davies.