THE PORTFOLIO FLOWS: Introduction 3


Here we find statistically positive contemporaneous covariance between (net) inflows and both dollar equity returns excess currency returns. The data also reveal strong evidence of correlation between net inflows and lagged equity and currency returns, with the sign generally positive. This is evidence that international investors are “trend chasers.” Indeed, trend chasing—interpreted to mean that an increase in today’s returns leads to an increase in future flows, without holding current and past inflows constant —seems to explain 60-85 percent of the quarterly covariance between emerging market inflows and returns. The flows are also correlated with future equity and currency returns in emerging markets. The predictability of future currency and equity returns explains between 20 and 40 percent of the covariance of quarterly returns and flows. International investors therefore appear to act on valuable private information on emerging markets.

Interestingly, the data provide no support for the hypothesis that flows into developed countries contain private information. To the contrary, in developed countries we fmd price pressure or overreaction of price to flow to be the dominant effect: today’s inflows predict prices will ease over time. Thus, developed markets appear to have both greater liquidity and greater informational efficiency than emerging markets.

While these findings are themselves provocative, we ask the data to go further. The third component of our investigation re-examines the predictability issue using the full bivariate behavior of returns and flows. This is a worthwhile exercise because the finding that returns predict future inflows may follow from the fact that returns are correlated with current inflows and, as noted above, inflows are persistent. In other words, in a world in which flows are autocorrelated and current flows move current prices, returns will predict flows. Trend-chasing behavior may be more stringently defined as predictability of future inflows over and above that implied by past inflows.

Similarly, we show that market indexes—particularly those of emerging markets—react sluggishly to news in that they display high-frequency positive autocorrelation. Given the sluggishness of market indexes, the covariance between contemporaneous inflows and returns suggests that inflows will predict returns. A more stringent test of whether investors are acting on superior information would therefore be to ask whether inflows predict returns over and above any predictability generated by past returns.