Risk speedometer: 2017 in review

January 31, 2018

 

Key highlights

  • The 1-month risk speedometer rose marginally in December but still finished near its lowest quartile historically. The 1-, 3-, and 12-month speedometers all remained below their 5-year averages.
  • Equity funds and ETFs took in $27.1 billion in total, with developed international and emerging markets funds and ETFs once again leading the way, gathering $19.2 billion.
  • U.S. bond funds and ETFs gathered $21.3 billion, while money market funds took in $43.8 billion.
 

December was another good month for global equity markets, with the FTSE Global All Cap Index advancing 1.7%. Equity funds and ETFs followed suit, with net cash flows of $27.1 billion. Flows into non-U.S. equity categories continued to be significantly stronger than for those into U.S. equities, with developed international and emerging markets products gathering $19.2 billion in total, while U.S. equity products had $6.1 billion in net inflows. (Sector flows accounted for the remainder of the total equity flow.)

For the second straight month, investors favored less risky assets, allocating $21.3 billion to taxable and tax-exempt U.S. bond funds and ETFs and $43.8 billion to money market funds.

The continued preference for less risky assets is clear in the risk speedometers. While the 1-month speedometer rose marginally in December, both it and the 3-month speedometer ended 2017 well below the 5-year average and near the bottom quartile of those readings. The 12-month speedometer also ended the year below its 5-year average. This slower-moving reading had been rising from a very low level for the first six months of the year but slid back down as the year progressed.

Vanguard's risk speedometers for December 2017

Vanguard's risk speedometers December 2017

Notes: Vanguard's risk speedometers measure the difference between net cash flows into higher-risk asset classes (U.S. equity, international equity, emerging markets equity, sector equity, alternative, and other taxable bond) and lower-risk asset classes (U.S. taxable bond, tax-exempt bond, and money market). The lighter-shaded areas represent values that are within 1 standard deviation from the mean, which means they occur roughly 68.2% of the time (34.1% higher and 34.1% lower). The middle shades represent readings between 1 and 2 standard deviations from the mean, occurring about 27.2% of the time (13.6% higher and 13.6% lower). The dark edges represent values more than 2 standard deviations from the mean, occurring the remaining 4.6% of the time (2.3% higher and 2.3 % lower). Speedometer values for previous periods may change from what was initially reported as the current value in prior periods because of changes made in the Morningstar, Inc., data and to the updating of the five-year average.

Source: Vanguard calculations, using data provided by Morningstar, Inc., as of December 31, 2017.

The "first-quarter effect"

From analyzing historical cash-flow data and our risk speedometer metrics, we have found a fairly strong correlation between the speedometers’ first-quarter readings and prior-year market performance.

For January, February, and March, the speedometers tended to follow the performance of the prior calendar year. When equities outperformed bonds in a calendar year, the speedometers rose in the initial months of the following year. And when the performance was reversed, the speedometers fell.

This trend was especially evident when we looked at the correlations calculated as the differential between global stock and global bond returns. From the chart below, we clearly see that the correlations were fairly strong in January and February for the 1-month speedometer, which in turn were reflected in the strong correlation of the 3-month reading through March.

Strong correlations between prior-year returns and risk appetite

Correlations of our risk speedometers with the differential between global stock and bond returns, 2002–2016

Strong correlations between prior-year returns and risk appetite

Note: Correlations are calculated between the 1- and 3-month risk speedometers and the performance differential of the FTSE Global All Cap Index and the Bloomberg Barclays Global Aggregate Bond Index (USD hedged).

Source: Vanguard calculations, using data provided by Morningstar, Inc.

So why were these first few months different? While many investors check the performance of their portfolios throughout the year, we surmise that the most common time to do so is in January, when statements are issued. Many investment committees and managers of other institutional portfolios also make decisions at the start of a new year. After seeing the performance for a full year, investors appear to direct more dollars to those investments that have done well and sell those that haven't.

However, while this type of decision is mostly attributed to the well-known investor behavior of recency bias, what investors may not realize is, they're doing the opposite of what prudent portfolio management would dictate, which is to develop an asset allocation and rebalance as needed.

This type of trading is not uncommon, because it's tempting to buy investments that have done well in the past, but the consequence of doing this may not be as obvious. Research we've conducted has shown that, on average, investors' actual returns lag their funds' returns (see Reframing investor choices: Right mind-set, wrong market).

How can advisors help combat the allure of market-timing and the temptation to chase performance? Keeping your clients on track through behavioral coaching can be the largest potential value-add you provide (see The evolution of Vanguard Advisor's Alpha®: From portfolios to people).

With 2017 behind us and many investors brimming with confidence, now is a good opportunity to remind your clients about their objectives and the plan you have in place to help them achieve them.

A decision to invest more in past winners could likely drift the portfolio further away from their target asset allocation. Instead, reinforce the importance of rebalancing. This approach has served investors well historically and can help close the "investor gap," the difference between fund returns and actual returns. With diligent behavioral coaching, one day the "first-quarter effect" could be synonymous with portfolio rebalancing.

Highest net inflows and outflows

Top winners
1-month inflows ($B) 3-month inflows ($B) 12-month inflows ($B)
Money market43.8 Money market88.3 Inter.-term bond150.5
Inter.-term bond15.7 Inter.-term bond47.1 Foreign large blend136.4
Foreign large blend12.9 Foreign large blend33.5 Money market 107.1
 
1-month inflows (% of AUM) 3-month inflows (% of AUM) 12-month inflows (% of AUM)
Cons. defensive5.3 Trading-inv. cmdty.26.0 Misc. sector94.9
Cmdy. ind. metals4.7 Misc. sector21.4 Volatility66.6
Long government4.4 Trading-levgd. debt8.9 Long government46.8

Note: Cash flows exclude funds of funds.

Source: Vanguard calculations, using data provided by Morningstar, Inc., as of December 31, 2017.

Top losers
1-month inflows ($B) 3-month inflows ($B) 12-month inflows ($B)
Large growth–6.4 Large growth–10.0 Large growth–56.2
High-yield bond–2.3 High-yield bond–8.0 Large value–27.4
Health –1.8 Health–5.0 High-yield bond–19.1
 
1-month inflows (% of AUM) 3-month inflows (% of AUM) 12-month inflows (% of AUM)
Trading-levgd. debt–32.7 Trading-levgd. debt–22.2 Cmdty. energy–20.5
Volatility–14.0 Cmdty. energy–16.1 Trading-levgd. debt–19.7
Trading-inverse equity–7.3 Trading-inverse equity–11.8 Single currency–19.6

Note: Cash flows exclude funds of funds.

Source: Vanguard calculations, using data provided by Morningstar, Inc., as of December 31, 2017.

More about Vanguard's risk speedometers

We've long tracked industry net cash flows to develop insights into what investors, collectively, are doing with a substantial portion of investable assets.1 Our risk speedometers—our unique lens on investor behavior that we began publically publishing in January 2017—and related cash-flow research also highlight trends that may not be apparent in raw cash-flow data. The result is a nuanced picture of how investors behave. These nuances sometimes reveal that the reality of investor behavior is more complex than conventional wisdom suggests.

Fran Kinniry, Don Bennyhoff, and Yan Zilbering of Vanguard Investment Strategy Group developed the risk speedometers to gauge the level of risk investors are taking in a given period. It's simply the difference in net cash flow between higher-risk asset classes, such as stocks, and lower-risk asset classes, such as fixed income. The speedometers compare investors' current risk-taking with longer-term averages.

One note of caution: While our readings are highly informative as to how cash flows are being invested in mutual funds and ETFs, we must remember that mutual funds and ETFs are not closed systems unto themselves. Rather, their flows are often also driven by cash flow from other assets within the much larger global capital market ecosystem.

For example, a large pension fund that manages a sizable bond mandate via a separately managed account could decide to liquidate that structure and move the assets into a bond ETF. This could result in a reading indicating a lower risk appetite in the mutual fund and ETF space when it was really just a substitution of a structure and not a reflection of risk appetite in the overall capital markets.

1 According to data from Morningstar, Inc., assets under management for U.S. open-end mutual funds, money market funds, and ETFs totaled $21.0 trillion as of December 31, 2017.

Notes:

  • All investing is subject to risk, including possible loss of principal.
  • Diversification does not ensure a profit or protect against a loss.
  • Investments in bond funds are subject to interest rate, credit, and inflation risk.
  • Foreign investing involves additional risks, including currency fluctuations and political uncertainty.
 

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