Mutual fund flows are one way of "following the money" to see how investors are feeling about the market. When investors are feeling bullish, with higher risk appetites, we tend to see net inflows into equity-based funds and outflows from bond funds. Conversely, a risk-off attitude might spark inflows for bonds and outflows from equities.
The Investment Company Institute is a great resource to track this information. In addition to following the activity in stocks vs. bonds, you can also determine whether investors are flocking toward domestic equities or global funds.
Quite simply, mutual fund flows help us to determine how much investors have poured into stocks relative to bonds, and whether one side of the trade might be getting a little crowded. If the equities market is moving higher, and we have yet to see significant inflows into equity funds relative to bonds, it can be a signal that there are still plenty of potential buyers out there to perpetuate future gains.
One sentiment indicator that we monitor each day is the Nova/Ursa ratio, provided by the Nova and Ursa funds from the Rydex Series Trust. The Nova fund is designed to have a target beta of 1.5. In other words, using shares of equities, stock index futures contracts, and options on those securities and futures, the fund has a target performance benchmark equal to 150 percent of the S&P 500 Index (SPX). Traders who invest in this fund are considered bullish on stocks.
The Ursa fund is designed to provide a performance inverse to that of the SPX by using a combination of short selling and options on stock index futures. Investors in this fund are considered bearish on stocks.
We can get an accurate view of the sentiment picture by comparing the amount of assets in each fund. Specifically, we divide the total assets in the Nova fund by the total assets in the Ursa fund to arrive at a Nova/Ursa ratio. A high Nova/Ursa ratio indicates an extreme amount of optimism (everyone investing in Nova) and a low Nova/Ursa ratio indicates an extreme amount of pessimism (everyone flocking to Ursa).
We have found that frequently lows in the Nova/Ursa ratio precede rallies in the SPX, while peaks in sentiment will often precede a decline in the index.