Significant investment funds often flow into asset classes as returns in those classes are peaking or have already begun to decline. While the correlations between these phenomena are not always highly predictable, some insight can be gained.
As reported by EPFR Global, a provider of fund-flows and asset-allocation data to financial institutions around the world, bond funds focusing on emerging markets debt securities were the largest beneficiaries of positive investment inflows in 2011. This asset class received approximately 7 percent of the reported inflows last year.
Close behind the emerging market debt funds were funds focused primarily on debt securities issued by U.S.-domiciled entities. These U.S.-focused debt funds received about 6 percent of the investment inflows.
Two equity categories suffered the largest outflows of funds in 2011. At a negative 11 percent and negative 12 percent, equity funds focused on emerging markets in Europe and funds focused on equities in Latin America reported the largest outflows, respectively.
Through the first few months of 2012, funds emphasizing corporate high-yield bonds had the greatest inflow of funds, receiving 6.3 percent of reported activity. Given the relatively high yield currently being paid by these funds, relative to investment grade bond funds and U.S. government-focused bond funds, these inflows are not surprising. The higher yields paid by these bond funds reflect the significant credit risk of the underlying corporate issuers of the high-yield debt. A downturn in economic health will likely increase the potential for default by these riskier corporate issuers, and the value of the securities in the high-yield bond funds will decrease.
During this same period of 2012, emerging market debt funds were the beneficiaries of the third-highest level of inflows, receiving 3.1 percent. As with the high-yield bond funds, the yields these emerging market debt funds are paying are relatively high, due to the credit risk of the underlying bonds in the funds. In addition to the credit risk of these funds, a material increase in interest rates will decrease the market values of these fixed-rate, emerging market bond funds.
As more and more investment funds flow into these yield-oriented vehicles, the prices will be pushed up and the market yields will decrease. Caution on the part of investors is warranted as more and more funds flow into these yield-focused categories.
Kirby Brown is the CEO of Beneficial Financial Group in Salt Lake City.