An empirical study shows that U.S. mutual funds take two major allocation decisions: bonds versus equity and U.S. versus non-U.S. assets. Federal Reserve policy easing encourages shifts into foreign assets. High uncertainty drives allocations out of risky assets into U.S. treasuries. And the relative performance of foreign versus U.S. assets leads a chase of the higher return. Within fixed income institutions tend to reallocate gradually towards higher prior yields.

Kroencke, Tim, Maik Schmeling and Andreas Schrimpf, “Global Asset Allocation Shifts”, Paper presented at BIS Research Network meeting on macroeconomics and global financial markets, March 19, 2015

The below are excerpts from the paper. Emphasis and cursive text have been added.

Measuring portfolio reallocation

“This paper studies global asset reallocation decisions of investors in U.S. domiciled mutual funds…Our results are based on detailed mutual fund data from EPFR Global, from which we can infer changes in fund investors’ portfolio allocations…Moreover, we can distinguish between retail and institutional investors, and the data allow us to track portfolio allocations, as opposed to simple fund flows…Our data are sampled at a weekly frequency…The period we study ranges from January 2006 to December 2014.”

The dominant factors of portfolio reallocation

“Global asset allocation shifts obey a strong factor structure, with two factors accounting for more than 90% of the overall variance of reallocations. The first factor captures around 80% of the overall variance [of portfolio reallocations] and can be interpreted as a rotation factor: It tracks rotation out of U.S. bonds and into U.S. equities. The second factor tracks shifts out of U.S. assets (bonds and equities) and into foreign assets. This factor captures reallocation decisions driven by international diversification motives of fund investors.”

Monetary policy and portfolio reallocation

“We find that institutional investors reallocate from basically all other asset classes to U.S. equities in the week prior to and during the week of FOMC meetings. On average, the overall amount reallocated from U.S. bond to U.S. equity funds in the week prior to and during the week of an FOMC meeting is USD 9.5 billion, a 22 basis point shift in the asset allocation. The amount reallocated from foreign to U.S. assets is USD 7.7 billion , which translates into an asset allocation change of 18 basis points. “

“We find evidence of an abnormal shift into U.S. equities irrespective of whether the FOMC meeting was associated with an easing (downward shift in the front end of the yield curve) or a tightening (upward shift). Hence, it is unlikely that our evidence on abnormal reallocations into U.S. equities (and out of everything else) is a mere artefact of our sample period, characterized by extraordinary monetary accommodation by the Federal Reserve.”

“We find that monetary easing induces U.S. fund investors to actively raise allocations to international assets, consistent with the view that investors search for higher returns abroad. At the same time, a yield curve flattening and a compression in term premia are associated with a shift out of equities and into U.S. bonds. All these effects tend to be more pronounced for institutional fund investors as opposed to retail investors.”

Uncertainty and portfolio reallocation

“Investors prefer U.S. equities over bonds when credit spreads rise but they prefer U.S. bonds in times of elevated stock market uncertainty and heightened risk aversion. For instance, a one standard deviation rise in the VIX translates into a 5 basis point reallocation by institutional investors away from equities and into bonds…. Similarly, we find that an increase in the VIX and in credit spreads induces U.S. mutual fund investors to cut back positions in foreign asset classes. Taken together, these results imply that investors retrench from basically all assets and reallocate towards U.S. bonds in times of higher uncertainty and risk aversion.”

Chasing returns

“We find that both retail and institutional investors chase returns internationally, in both equities and bonds…Reallocations of retail and institutional investors, by contrast, are both strongly related to past performance. Thus, high past returns to foreign as opposed to domestic assets induce fund investors to reallocate more heavily towards foreign assets. At the 12-week horizon, both types of investors raise their allocation to international assets significantly by about 10bps when international assets outperform domestic assets by one standard deviation…Institutional investors react considerably faster when high foreign returns are observed.”

Search for yield

“When constraining the investment universe to bonds… we find that institutional investors reallocate more heavily to segments with a high prior yield, consistent with search for yield behavior. These investors tend to increase their bond allocation within a week such that they increase the (per annum) yield by an additional 6 bps…No such search for yield behavior can be observed for retail investors.”

N.B. ‘Search for yield’ or ‘reach for yield’ typically describes regulated investors’ preference for high-risk assets within the confines of a rule-based risk metric (such as credit ratings or VaR). It is a form of regulatory arbitrage and source of inefficiency (view post here).

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.