THE PORTFOLIO FLOWS: The Interaction Between Flows and Returns 5

Table 9 reports our estimates of the structural parameters, a, b, c, e. Note that the magnitude of coefficient e is affected by the fraction of true inflows that are captured by our data. If State Street clients’ share of total inflow into developed countries is half of their share into emerging markets, then we would expect the developed countries’ coefficient to be twice as large. In any case, our estimates of e are positive and statistically significant.

The estimate for the world suggests that a positive shock to inflows equal to 1 basis point of capitalization results in a contemporaneous increase in prices of 68 basis points. The corresponding coefficient for developed countries is 90 basis points. Of course, if these State Street’s clients account for a fifth of total inflows, then the semi-elasticity is one fifth as big. Even so, this would still be a larger sensitivity to prices than has been previously estimated for flows into US mutual funds.

The estimates of с are universally negative, with all but one being statistically significant at the 5% level. Note that a negative estimate of с (combined with the positive coefficient e) suggests that temporary inflows result in a temporary price increases. However, this does not mean that inflows forecast returns negatively—inflows are strongly persistent as we have seen, so that it is unlikely that inflows today will subside fully tomorrow. Thus, the information content in inflows—which we have seen to be positive in emerging markets—is a result of fact the current inflows predict future inflows, and future inflows drive up future prices.

This story has interesting implications for crises—such as Mexico and Southeast Asia—in emerging markets. Much debate has focused on whether international investors sold at the beginning or in the midst of the crises. While we have already shown that net sales are small, our last results suggest that prices fall when international inflows subside. Prices, which were rationally high in expectation of further inflows, appear not to be sustainable once the inflows cease. Thus, our estimates of с and e suggest how a fall in emerging market inflows can be associated with price declines.

Given the parameter estimates in Table 9, what is the cumulated impact over time of flows and returns if there is an unexpected shock to flows? Panel В of Table 9 answers this question. It shows the cumulative change in flows and returns over the next 32 days after current flows are shocked by 1 basis point. Cumulated flows increase by 1 to 2 basis points (beyond the initial shock) over that time. Returns, however, increase by a much larger multiple. A 1 basis point shock to flows (i.e., a 1 basis point unexpected inflow) results in a 50 to 400 basis point increase in emerging market returns. Measured in this way, the impact of flows on prices is very large indeed. If State Street’s share of the market is even 10%, these numbers represent semi-elasticities of between 5 and 40.