We find a statistically positive contemporaneous covariance between net inflows and both dollar equity and currency returns.3 The data also reveal strong evidence of correlation between net inflows and lagged equity and currency returns, with the sign generally positive. This pattern suggests that international investors engage in positive feedback trading, also called “trend chasing.” Indeed, positive feedback trading behavior, 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% of the quarterly covariance between net inflows and returns. The flows are also correlated with future equity and currency returns in emerging markets. The predictability of future equity returns explains between 15% and 35% of the covariance of quarterly returns and flows. This prediction is consistent with international investors having valuable private information on emerging markets. It is also consistent with a story in which price pressure by international investors, combined with the persistence of their flows, generates return predictability.
Fourth, we examine the conditional relationships between flows and returns. This exercise is worthwhile, 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. In this setting, a more stringent definition of trend-chasing would look for predictability of future inflows over and above that implied by past inflows. Alternatively, if current flows move current prices and if prices are positively autocorrelated, as we demonstrate to be true of emerging markets, then inflows are likely to predict returns. This reasoning gives rise to the question of whether inflows can predict returns after conditioning for the effects of past returns.
Using a bivariate VAR model to test these relationships, we find that returns help to predict flows over and above the predictability of past flows. So the trend-chasing characteristic of the data meets the more stringent test. Past flows also remain important for predicting future flows once lagged returns are included. However, the statistical significance of lagged returns falls considerably. On the prediction of returns, we find that emerging market returns are predicted by the flows, after taking into account past returns. The direction of this effect is the same for developed countries, but with little statistical significance. One possibility is that the noise in flows allows lagged for developed country returns to pick up any predictive element in the flows that is incorporated into past return data.