What Could ETF Outflows Be Telling You?

Nathaniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

One of my friends recently showed me a great tool for viewing the inflows and outflows of virtually every exchange traded fund on the market. If you go to Index Universe's website, you can navigate any array of data, including a tool which will give you the ability to determine the top fund inflows and outflows for any period in time.

Last weekend I though it would be interesting to view the previous week's top outflows. What I found intrigued in me as the top outflows were seen in this year's outperforming segments of the market including long equities, real estate, and leveraged long equity notes. The following diagram shows the top three outflows for the period of June 30 through July 6.

Leading the list with $1.4 billion in outflows was the iShares Core S&P 500 ETF (NYSEMKT: IVV). As the name would imply, the fund directly tracks the returns seen in the broader index. When outflows occur, it means selling demand outpaced that seen within the broader index, thus the fund needed to liquidate assets to stay tied to the S&P. Perhaps the selling pressure is a delayed reaction to the volatility seen over the past 3 weeks. Interest rate pressure may have tempted some investors back into the slightly higher yielding bond market.

Both shorter term and longer dated rates have risen sharply since Bernanke shook the market with hints of tighter monetary policy. Should interest rates continue higher, pressure would be felt in the margin markets as well. The NYSE reported the highest recorded level of margin borrowings, should interest rates rise, some may no longer be able to afford margin to finance their long positions, and thus selling would be necessary. One can speculate as to why the fund was seeing outflows all day long, but we can conclude the outflows aren't a bullish indicator at this point in time. 

Coming in second, the ProShares Ultra S&P 500 ETF (NYSEMKT: SSO) is designed to amplify the returns of the S&P for investors. This is yet another example of a risk product created for investors. Leveraged fund and notes generally seek to multiply the returns of an underlying index, security, or commodity for the benefit of the investor. This fund specifically trades with a 2:1 leverage ratio, meaning if the S&P returns 1% today, the fund will return 2%. However, these funds can be especially dangerous during times of turbulence, as two things occur. First, investors can lose large amounts of money when the the underlying index turns negative as the returns are both leveraged to the upside and the downside. For example, if the S&P goes down 2%, the fund will return -4% in line with the 2:1 ratio. Second, the increased volatility may lead to discrepancies between the underlying products and funds due to the liquidity of some these products. Going forward, we have to attribute these outflows to the same causes as the outflows previously mentioned. Higher interest rates may have caused a negative reaction by decreasing the demand for equities. 

Lastly, the iShares Dow Jones U.S. Real Estate ETF (NYSEMKT: IYR) had a little over $700 million in outflows. Up until recently, the real estate sector, including the home builders, materials, and improvement companies, have performed exceptionally well. Strong demand, rising housing prices, and low interest rates fueled the multiple expansions of much of the sector year to date. However, mortgage rates have started to rise from the record lows seen just a month ago.

Since bottoming out at just below 3.4%, the average 30 year mortgage rate has risen over 100 basis points. While a single basis point doesn't sound significant when you considers the historical context of the rate, 1% may keep new homeowners and investors away from the market. As the spread between rental yield and interest rates narrows, the opportunity costs for property investors grows, thus making an investment in property less attractive. Up to this point, much of the housing recovery has been a result of investor demand. One can speculate the outflows are a reaction to fears of declining demand. Should interest rates continue higher, I would watch for multiple contractions within the housing sector. 

One sentence wrap-up

At the end of the day outflows don't directly predict future downside moves, yet the outflows do highlight a drop in demand for the underlying sector or index. 

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Nathaniel Matherson has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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