ETF perspectives: Q2 markets moved higher, but inflationary uncertainty persists

ETF perspectives: Q2 markets moved higher, but inflationary uncertainty persists

Expert Perspective

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August 15, 2024

Each quarter, we bring you the latest ETF trends and insights from our investment experts to help you address issues that may affect your clients’ portfolios.

 

Samuel Martinez portrait
Samuel Martinez, CFA
Head of Index Fixed Income Product
Samuel Martinez portrait

Samuel Martinez, CFA

Head of Index Fixed Income Product

Portrait image of Andrey Kotlyarenko
Andrey Kotlyarenko, CFA
Equity Index Senior Investment Product Manager
Portrait image of Andrey Kotlyarenko

Andrey Kotlyarenko, CFA

Equity Index Senior Investment Product Manager

David Sharp portrait
David Sharp
Senior ETF Capital Markets Specialist
David Sharp portrait

David Sharp

Senior ETF Capital Markets Specialist

 

Key highlights

  • ETF inflows show that investors continue to evaluate next steps amid signs of a likely rate cut.
  • Bond ETF performance and yields examined in the aftermath of rising rates and inflation.
  • Active ETFs are on a trajectory of declining costs as their popularity has expanded.

 

Industry assets and cash flow

Industry assets and cash flow

The S&P 500 Index moved 4.3% higher in the second quarter as the U.S. economy added more jobs, while the bond markets idled a bit, rising 0.08% amid mixed news on inflation.1 Additionally, the unemployment rate fell below 4%, while the core Consumer Price Index rose 0.2% month-over-month in May and edged 0.1% higher in June.2 Still, the Federal Reserve remains committed to delaying a rate cut amid strong labor market conditions, as well as concerns that inflationary pressures may persist.

Regarding flow trends, ETF investors reacted to these market conditions with some consistent behaviors, plus a few new ones. Equity ETF inflows totaled $141.8 billion, with large-blend and large-growth ETFs consistently leading the pack. Meanwhile, foreign large-blend ETFs saw more inflows, a possible reflection of investor preference for greater diversification amid the growing concentration in some large U.S. companies. Fixed income inflows were $68.5 billion, with ultrashort ETFs representing the most popular asset class and intermediate categories generating significant interest as well, in a sign that investors could be recalibrating their duration. High-yield ETF flows rose in May, while corporate bond ETFs saw limited inflows at a time of historically tight spreads.

 

Q2 2024 change in ETF industry assets

A bar chart shows how ETF industry assets rose from $8.89 trillion at the end of Q4 2023 to a record $9.20 trillion at the end of Q1 2024. Market appreciation accounted for $95.4 billion of that growth, while cash flow added $216.1 billion in assets.

Sources: Vanguard, based on data from Morningstar, Inc., as of June 30, 2024.

Equities spotlight

Rising allocations to international equity ETFs

Flows into international equity ETFs appear to be accelerating so far in 2024, suggesting U.S. investors may be growing concerned with the potential risks of home bias and focusing too much on a U.S stock market that has now climbed roughly 2.5 times as high as its COVID-19-era low in March 2020.3 International equity flows of $57 billion through June of this year, while well short of the $199 billion pulled in by U.S. equity strategies, notably exceed 2023’s first-half international equity flows of $52 billion.4

With these inflows in mind, it’s a good time to take measure of why such diversification may be critical to long-term investing success:

  • Concentration risk: Focusing too much on one geographic area or investment sector introduces the risk of a bad apple spoiling the barrel. Put another way, diversifying holdings can potentially introduce a buffer into portfolios that can offset losses. In recent years, U.S. equities have become top-heavy with some of the more conspicuous tech names, the so-called “Magnificent 7.”5 Almost 30% of Vanguard Total Stock Market ETF (VTI) consists of these holdings. Lowering VTI exposure to 60% and adding 40% of international exposure in the form of Vanguard Total International Stock ETF (VXUS) would cut this concentration to 17%.
  • Volatility reduction: Our research of investment portfolios over the past 10 years shows that an allocation to international stocks ranging from 20% to 50% of total equity holdings can reduce portfolio volatility by as much as 5%.
  • Benchmark allocations: As a reality check, it’s worth remembering that many global equity benchmarks, including the FTSE Global All Cap Index on which Vanguard Total World Stock ETF (VT) is based, have about 62% exposure to U.S. stocks.6 With 76% of equity ETF flows favoring U.S. stocks the past three years, according to Morningstar, Inc., investors could still be well shy of global market allocations. Such benchmark allocations are based on careful research of each region’s contributions to global GDP, and the market capitalization of the securities in each of those regions. Deviations from the benchmark may lead to unwanted deviations in performance.

 

Flows into international equity ETFs as a percentage of all equity ETF inflows

Flows into international equity ETFs as a percentage of all equity ETF inflows (p. 3, right side)	A chart shows flows into international equity ETFs as a percentage of all equity ETF inflows during recent quarters. There is a trend of increased international emphasis during the first half of 2024 compared with the second half of 2023. The international percentage stood at 13.0% at the end of Q3 2023, and then dipped to 11.5% by the end of Q4 2023. The percentage rose to 22.9% by the end of Q1 2024, before edging down to 21.6% at the end of Q2 2024.

Source: Vanguard, as of June 30, 2024.

Equity ETF cash flows ($B)

Chart shows Q2 equity ETF flows by category and style. U.S. equity ETFs had inflows of $104.7 billion, international equity ETFs had inflows of $28.9 billion, sector ETFs had inflows of $0.4 billion, and nontraditional ETFs had inflows of $7.9 billion. Breaking down U.S. equities by style, large-cap value had inflows of $5.5 billion, large-cap blend had inflows of $56.4 billion, and large-cap growth had inflows of $29.5 billion. Mid-cap value had inflows of $1.9 billion, mid-cap blend had inflows of $8.7 billion, and mid-cap growth had inflows of $2.3 billion. Small-cap value had inflows of $1.5 billion, small-cap blend had outflows of $1.1 billion, small-cap growth had no net inflows or net outflows.

Notes: Data based on U.S.-listed issues only, not including ETNs.

Sources: Vanguard, based on data from Morningstar, Inc., as of June 30, 2024.

Fixed income spotlight

Reexamining bond ETF metrics post rate hikes

As the market starts to consider a changing environment where yields begin to fall, the topic of “locking in rates” has grown in focus. Ten-year Treasuries are now yielding 4.36%, while 2-year notes now yield 4.71%, compared with 1.52% and 0.73%, respectively, at the end of 2021.7 In view of these increases, some advisors are considering adding exposure to fixed income ETFs in their portfolios.

Several yield metrics are quoted for bond ETFs, and investors might not always be able to map relevant bond-fund metrics to what they’re hearing on CNBC or seeing in The Wall Street Journal—as many financial media outlets tend to focus on changes in the federal funds rate, Treasury yields, or 30-year mortgage rates.

SEC yield versus distribution yield

Two of the most commonly consulted metrics for bond ETFs are:

  • SEC yield: Reflects the average yield to maturity experienced in a portfolio over the past 30 days.
  • Distribution yield: Refers to the actual income that the fund distributes.

Due to the relatively recent 30-day time frame, SEC yields adjust quickly to changes in market rates and can be a timely representation for the yield to maturity on the underlying portfolio of bonds. On the other hand, distribution yield is based on the yield of a specific security at the time the fund purchased the bond. Because ETFs can hold bonds for many years, the distribution yield can be slow to adjust to benchmark yield changes.

With any bond ETF, it’s important to remember that income and price both play a part in the return. So an investor isn’t necessarily missing out on return if an ETF has a low distribution yield relative to its SEC yield, because more return may come from rising bond prices.

As illustrated in the chart below, the SEC yield for “ETF A” was quick to adjust to the sharp rise in interest rates beginning in late 2021 and continuing through early 2023, while the distribution yield has increased more gradually. When trying to understand how quickly these two metrics will converge for an ETF, it’s important to consider portfolio turnover. Higher portfolio turnover means that bonds with updated yields get recycled into the portfolio more quickly, which causes distribution yield to adjust more rapidly. Should rates fall, SEC yields will decline more quickly than distribution yields because it will take time for bonds to cycle out of the portfolio.

So how does this relate to locking in rates? When you buy an ETF, you are buying a slice of the underlying bonds in the portfolio at a particular yield and price point. While yields can move from there, the SEC yield at your entry point can be a strong predicter for an ETF’s total return over its duration. The actual income payments on a product will move gradually over time, but investors who allocate today are essentially “locking in” the total return profile of current interest rates.

 

SEC yields and distribution yields for “ETF A” from July 31, 2019, to June 30, 2024

SEC yields and distribution yields for “ETF A” from July 31, 2019, to June 30, 2024 (p. 4, right side)	A chart shows monthly distribution yields and monthly SEC yields on a hypothetical “ETF A” from July 2019 through June 2024. SEC yields rose sooner than distribution yields as interest rates increased in 2022 and 2023. More recently, as sentiment has begun tilting toward the Federal Reserve lowering official rates, SEC yields have begun edging downward. The implication is that because distribution will take longer to head downward, investors in bond ETFs can potentially reap the benefits of relatively higher rates for a longer period of time, because it takes time for higher-yielding bonds to roll out of the portfolio as prevailing rates decline.

Note: This figure shows the relationship between distribution yield (green) and SEC yield (gold).

Source: Vanguard.

Fixed income ETF cash flow by category ($B)

ETF industry snapshot with two tables. One table shows cash flows into broad fixed income categories and the second table shows U.S. taxable fixed income Q2 cash flows.

Notes: Data based on U.S.-listed issues only, not including ETNs. “Other” includes ETFs in Morningstar’s Preferred Stock, Bank Loan, Multisector Bond, Nontraditional Bond, and Target Maturity categories.

Sources: Vanguard, based on data from Morningstar, Inc., as of June 30, 2024.