[This article previously appeared on our sister site, IndexUniverse.eu.]

The great equity rotation is the hot investment topic of the year: are investors finally ending their love affair with bonds and once again embracing equities? There are encouraging signs that investors have shrugged off their risk aversion: the FTSE 100 has reached levels not seen since before the financial crisis and the S&P 500 is close to levels last seen in July 2007.

Investors’ greater comfort with equities can be traced back to two important triggers, says Edmund Shing, S&P Dow Jones Indices’ director of index investment strategy. “The US stepping away from the fiscal cliff, albeit temporarily, as well as the actions of the ECB in concert with some European politicians have reassured investors that extreme risks have been removed.”

The strong rebound in equities has been accompanied by strong inflows into passive equity investment vehicles. BlackRock’s most recent global monthly ETP overview noted that there were record breaking inflows of $40.2bn in January with equities accounting for 94 percent and fixed income activity remaining subdued.

Stephen Cohen, head of investment strategy & insight at iShares, says: “Strong inflows into equity ETFs started in late 2012 which continued into the start of this year. Both developed and emerging market equity ETFs were popular with investors.”

While there’s no doubt that investors are much more positive about the prospects for equities, as reflected by the asset inflows, there’s a greater question mark whether this is truly a “rotation” of assets out of fixed income into equity.

Shing says: “The improved performance in equities has been accompanied by bond yields drifting higher which has provided fuel for the great rotation theory. But there has not been any bond asset outflow from either US mutual funds or ETFs. It’s new cash that has been going into equities.”

European Interest In Equities

The strong interest in equities is not confined to the US market; they are also prevalent in Europe. “In the UK retail market, corporate bond ETF and unit trust funds were the most popular for most of last year. But in the last quarter of last year, flows started to move in favour of equities,” says Shing.

In Europe, the majority of financial market assets are controlled by institutional investors such as pension funds and insurance companies. A true rotation out of fixed income and into equities would require these investors to start switching from bonds into equities.

But there are considerable regulatory and accounting restraints that could prevent a large scale switch. Insurance companies will have to comply with Solvency II regulations which will impose a stricter risk management regime. And pension funds must satisfy both regulatory demands for greater stability as well as corporate sponsor requirements for less volatility.

Sascha Levitt, Deutsche Bank's European ETF strategist, says: “The large European institutions are not yet buying into equities in large volumes. Even now most European pension funds only have a single digit percentage equity asset allocation.”

Multi-asset managers, however, do not face such constraints and are paid to make the most of price dislocations in different asset classes and have already moved money from fixed income into equities.

Moving Assets

Alan Miller, chief investment officer at SCM Private, says: “By the autumn of last year, we held the view that bond valuations were getting incredibly stretched. That was the first time that we took a significant amount of money out of bonds to put into equities.”

SCM Private allocated money to low yet consistent growth equities which pay good dividends by investing in higher-yield equity ETFs.

“While these lower growth equities will probably not see their value appreciate as much as other equities in a rising market, we believe that this investment is still very favourable compared to bonds because the starting yields are significantly higher with the additional kickers of real dividend growth and capital appreciation” says Miller.

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