New research

Corona Del Mar, CA

Howdy Friend,

I read papers so you don't have to. After a long search, I discovered a research paper on ETF Fund Flow data.

Its conclusions were stunning...but first some background:

The main question the paper tries to answer is: What happens to the prices of stocks when there's a significant inflow of money into the ETFs that hold those stocks? This is important because ETFs are different from mutual funds. In mutual funds, when people invest money, the fund manager uses that money to buy more stocks.

But in ETFs, the process is a bit more complicated. Instead of money, big financial institutions, known as "Authorized Participants," bring in a basket of stocks to the ETF and get ETF shares in return. This unique process makes ETFs an interesting subject to study.

The Method: How Did They Study This?

To answer this question, the paper looked at 286 U.S. equity ETFs from the years 2000 to 2010. Equity ETFs are those that invest in stocks. The study used statistical methods like panel regressions and vector auto-regressive analysis (VAR) to dig deep into the relationship between ETF inflows and stock prices (it may qualify as one of the toughest papers I've ever had to decipher).

The Findings: What Did They Discover?

The study found something fascinating. When there's a significant inflow into an ETF (meaning a lot of new stocks are brought into the ETF by Authorized Participants), the prices of those stocks go up. It's like a wave of popularity suddenly hits those stocks, and everyone wants a piece of the action.

But here's the catch: this price increase is temporary.

After about five days, the prices start to go back down. In fact, 38% of the initial price increase reverses itself within this period. In other words -- mean reversion. Why does this happen? Well, the study suggests that the initial price increase is due to something called "price pressure."  When a lot of new stocks are added to an ETF, it creates a demand for those stocks, pushing their prices up.

But this demand is not always based on the actual value or performance of those stocks. So, after 5 days, the market corrects itself, and the prices start to go back down.

Why Is This Important?

Understanding this pattern is crucial for traders. If you know that a significant inflow into an ETF temporarily pushes up stock prices, you can make more informed decisions. For example, you might decide to sell those stocks when their prices are high and buy them back when the prices go down. This knowledge can give you an edge in the stock market game...you do trade on proven edges right? Right? RIGHT?

The glaring chapter missing from this study is of course what happens after fund outflows. I'm guessing that prices of stocks go back up...but I wouldn't assume that without testing first. They also didn't do a study of what happens when you combine ETF mispricing data with the fund flow data.

(I have! But it's hush hush for now)

Since semiconductor stocks are all the rage, let's take a look at SMH, a popular semiconductor ETF, fund flows:

Funds are flowing out of this ETF.

Same with QQQ.

However, funds are flowing massively into the leveraged Nvidia ETF:

I mentioned earlier this week that Josh's NVDA strategy has TOO HOT of a hand, and the AI stopped picking it's signals.

Weird right?

But you know what the real kiss of death is?