Each December, billions of dollars flow into the SPDR S&P 500 (NYSEArca: SPY). And each spring, billions of dollars flow back out again.

The annual ebb and flow is as reliable as the change of seasons, but much more mysterious. To date, no one has fully explained what drives the movement of assets, which can be enormous. In December 2009, for instance, $11 billion flowed into SPY, while $16 billion flowed out in January. In 2008, $16 billion flowed into the fund in December, and $2.1 billion flowed out in January (based on month-end prices and net creations).

What drives these flows? The answer is complex. There’s no single force causing billions to move in and out of this ETF around year-end. But a few complementary factors—including two somewhat complicated tax maneuvers—appear to be contributing to the moves.

Equitizing Cash

The conventional explanation for what drives these flows is end-of-year cash equitization. December, after all, is a reporting month. Most mutual funds, hedge funds and investment advisors are required to file year-end statements with the Securities and Exchange Commission detailing exactly what securities and cash they hold in their portfolios.

Managers want to look good in these statements, as they are often relayed to clients, and are publicly available on www.sec.gov. As a result, reporting season turns into a fashion show.

The two things advisors want to avoid during these fashion shows are 1) owning “dogs”—stocks or funds that are trading down big and that people don’t like, and 2) holding cash. The two are related, because when managers sell poorly performing stocks and book losses at the end of the year, they end up with excess cash. Most managers don’t want to report a large cash position, because investors aren’t paying them management fees to sit on cash.

What do you do? You “equitize” that cash, quickly putting it to work in the market.

Sometimes, managers will have a wish list of stocks, bonds or ETFs that they want to own, and will put this cash to work buying positions they’re genuinely happy to own. But sometimes, they won’t be dying to purchase anything, and just want to get their cash working ... somewhere.

Often, that means buying simple benchmark exposure. And often, that means buying the most liquid security in the world: SPY.

In a recent blog on the topic, Matt Hougan was skeptical about whether cash equitization could explain the huge flows into SPY. He pointed out, rightly, that the S&P 500 isn’t the whole market. If equitization were the primary driver, one would expect to see similar activity in ETFs like the iShares Russell 2000 Index Fund (NYSEArca: IWM) or the ever-popular PowerShares QQQ (NYSEArca: QQQQ). Those funds exhibit nothing as predictable or dramatic as SPY’s seasonal flows.

That said, SPY is the most liquid ETF in the world, often by a factor of two; indeed, on many days it’s probably the most liquid single security in the world. And the data show that the big buyers of SPY in December are the largest institutional investors, folks who care deeply about liquidity. The table below shows the five firms that added the largest positions in SPY in the fourth quarter of 2009. For a firm like JP Morgan, that was moving more than $4 billion into SPY, liquidity matters.

Source: Bloomberg

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